CALLS VS PUTS EXPLAINED WITH SIMPLE EXAMPLES

What are Call and Put Options?

Call and put options are two foundational instruments in options trading. These financial contracts grant the holder the right—but not the obligation—to buy or sell a specific asset at a predetermined price before a certain expiration date.

Here is a straightforward breakdown:

• Call Option: Grants the holder the right to buy an underlying asset at a specified price (strike price).
• Put Option: Grants the holder the right to sell an underlying asset at the strike price.

These instruments are largely used in equity markets but can apply to any asset class, including commodities, currencies, and indices. Traders use options either for speculation or for hedging existing positions.

Components of an Option Contract

To start understanding how calls and puts function, you must become familiar with the essential elements of any options contract:

• Strike Price: The specific price at which the asset can be bought or sold.
• Expiration Date: The last date the option can be exercised.
• Premium: The total cost to purchase the call or put; this is paid upfront by the buyer to the seller.

Options are classified as either in the money, at the money, or out of the money depending on how the strike price compares to the current market price of the asset.

Basic Strategy Overview

The main appeal of options is their ability to allow control over a larger number of shares or assets at a fraction of the price, due to the leverage they offer. However, this also increases potential risk. Here’s a quick snapshot:

• Call Buyers: Profit when the asset’s price goes up.
• Put Buyers: Profit when the asset’s price goes down.
• Call Sellers: Hope the asset’s price remains below the strike price.
• Put Sellers: Hope the asset’s price remains above the strike price.

Understanding the interplay between price movements, strike prices, and premiums is essential to making profitable decisions with calls and puts. The next sections walk through practical examples to clarify how profit and loss (P&L) work in each case.

Call Option: Profit and Loss Examples

Let us consider a call option example to understand how profits and losses come into play. Suppose you believe that the share price of a company, XYZ Ltd, will rise in the near term. Currently, XYZ Ltd trades at £50 per share.

Call Option Purchase Details

• Strike Price: £55
• Premium Paid: £2 per share
• Contract Size: 100 shares (typical for standard options)
• Total Investment: £2 × 100 = £200

Scenario 1: Share Price Rises to £60

• You exercise your call to buy shares at £55.
• Market price is £60, so your immediate value per share is £5 (£60 - £55).
• Profit per share = £5 - £2 = £3, or £300 total (3 × 100).

Conclusion: The call option yields a net profit of £300, offsetting the £200 initial investment and returning £100 in overall profit.

Scenario 2: Share Price Remains at £52

• The market price is below the £55 strike, making the option out of the money.
• You choose not to exercise.
• Total loss = Premium paid = £200.

Conclusion: The maximum loss you endure as a call buyer is the premium you initially paid.

Key Insights for Call Buyers

• The upside is virtually unlimited if the share price surges.
• The downside is limited to the premium invested.
• Breakeven Point = Strike Price + Premium = £55 + £2 = £57.

This summary shows that buying call options can be a cost-effective bullish strategy, particularly when large price movements are expected within a short window.

Writing Call Options

On the other hand, selling (or writing) a call means assuming the obligation to sell the stock if the buyer exercises the option. Here's what that might look like:

• Strike Price: £55
• Premium Received: £2 per share

Outcomes for Call Seller

• If the price stays under £55, the option expires worthless, and the seller keeps £200.
• If price goes over £55, say to £60, the seller must sell shares at £55, losing £5 per share but gaining £2 in premium, netting a £3 loss per share, or £300 total.

Conclusion: The call seller has limited upside (premium received) but faces potentially unlimited losses if the share price skyrockets.

Put Option: Profit and Loss Examples

Put options work oppositely to calls—they allow the holder to sell an asset at a predetermined price. Investors buy puts when they expect the share price to decline. Let's analyse how it works using a simple scenario.

Put Option Purchase Details

• Underlying Asset: XYZ Ltd
• Current Market Price: £50
• Strike Price: £45
• Premium Paid: £1.50
• Contract Size: 100 shares
• Total Investment: £150

Scenario 1: Share Price Drops to £40

• As the market falls below the £45 strike, you exercise your put option.
• You sell shares at £45 while the market price is £40, gaining £5 per share.
• Net profit = £5 - £1.50 premium = £3.50 per share, or £350 in total.

Conclusion: The put option generates a notable profit as the stock declines, justifying the premium invested.

Scenario 2: Share Price Rises to £48

• The market value is above the strike price (£45), so the put option is out of the money.
• You do not exercise and let the option expire worthless.
• You lose the entire premium – £150.

Conclusion: Loss is limited to the premium paid, providing a relatively low-risk way to speculate on falling prices.

Breakeven and Maximum Scenarios

• Breakeven Point = Strike Price - Premium = £45 - £1.50 = £43.50.
• Maximum Profit: If the stock falls to zero, max gain = £45 - £1.50 = £43.50 × 100 = £4,350.
• Maximum Loss: If stock stays above £45, loss = £150 premium.

Thus, buying puts represents a bearish strategy with limited loss and significant upside.

Writing Put Options

Sellers of puts agree to buy the stock at the strike price if the buyer exercises. Here's what that entails:

• Strike Price: £45
• Premium Received: £1.50 per share

Outcomes for Put Seller

• If the stock stays above £45, the seller keeps £150—best-case scenario.
• If the stock drops to £40, the obligation is to buy the stock at £45. Immediate loss = £5 - £1.50 = £3.50 per share, or £350 total.

Conclusion: Put sellers expose themselves to potential high losses if the asset drops sharply, but they retain collected premiums when prices hold steady or rise.