If you’ve been reading about finance in the past couple of years, you’ve almost certainly heard of options — and their meteoric rise in popularity.
Much of that surge in popularity can be attributed to the availability of options on low-cost, mobile-friendly trading platforms such as Robinhood. Almost anyone can trade options — even if they don’t really understand what they are or how they work.
The options-trading world is complicated and can involve a lot of jargon. One of its most fundamental concepts — the call vs. put distinction — can be confusing for many beginners.
What are puts and calls?
Puts and calls are the types of options contracts, and both types have a buyer and a seller.
So while most financial markets have only two types of participants — buyers and sellers — the options market has four: call buyers, call sellers, put buyers and put sellers.
Selling an option at its origin — as opposed to reselling a put or call you originally bought — is also known as “writing” an option.
When you buy a call, you make a small payment, or the “premium,” in exchange for the right to purchase the underlying stock at a set price, or the “strike price,” on or before a specified date, or the “expiration."
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Buying a put is similar, except it gives you the right to sell the underlying stock at the strike price on or before expiration.
Calls are profitable for buyers, or “in the money," when the market price of the underlying stock is above the strike price because exercising the option, or buying the stock at the strike price, would mean buying the stock for less than it’s worth.
Puts are profitable for buyers when the underlying stock is trading below the strike price because exercising the option would mean selling the stock for more than it’s worth.
But puts and calls don’t just have buyers; they also have sellers.
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Paper trading allows you to practice advanced trading strategies, like options trading, with fake cash before you risk real money. Here are the brokerages that offer free paper trading accounts.When you write a call, you collect the premium from the buyer, and in exchange, you’re obligated to sell the underlying stock to the buyer for the strike price — if they choose to exercise the option before expiration.
Call sellers hope that doesn’t happen. If the option is in the money and the buyer exercises it, then the seller has to give them the underlying stock for less than it’s worth. If the option is out of the money and the buyer doesn’t exercise it, then the seller gets to keep the premium without doing anything.
When you sell a put, you collect a premium from the buyer, and in exchange you agree to buy the underlying stock from the buyer at the strike price — if they exercise the option before expiration.
Put writers hope the underlying stock trades above the strike price so the option is out of the money and expires worthless and they can keep the premium. Otherwise, if the option is in the money and the buyer exercises it, the put writer has to buy the underlying stock from them for more than its market value.
The four options market participants and their incentives
Call | Put | |
|---|---|---|
Buyer | Bullish. Hopes the underlying stock will trade above strike price by expiration so the option can be exercised or resold. | Bearish. Hopes the underlying stock will trade below strike price by expiration so the option can be exercised or resold. |
Seller | Bearish. Hopes the underlying stock will trade below strike price at expiration so the option expires worthless and they can keep the premium. | Bullish. Hopes the underlying stock will trade above strike price at expiration so the option expires worthless and they can keep the premium. |
» Need to back up a bit? Check out our primer on how to trade options.
Buying call options vs. buying put options
Traders usually buy call options on a stock when they are very bullish on that stock and want bigger gains than those from simply owning the stock. If the stock is trading above the strike price at expiration, then a call buyer can exercise or resell the option for a profit.
So buying calls can be a way of “doubling down” on a stock you own or a way of speculating on a stock you don’t own.
Call buying may require a smaller initial investment than buying the equivalent number of shares in the stock itself — although it comes with a substantial risk of losing that entire investment. If the stock is worth even a cent less than the strike price at expiration, the call will expire worthless and you’ll lose all the money you paid for it.
Conversely, traders usually buy puts on a stock as a means of betting against that stock. Many prefer it to short selling — another way of betting against a stock. Short selling losses can exceed 100% (and are potentially unlimited) if the stock rises enough, while the worst-case scenario in put buying is losing 100% of the money you paid for the option.
» Want to learn more? Read about the ins and outs of short selling.
In a “protective put” strategy, a trader might buy a put on a stock that they own, typically with less money than they paid for the stock. That way, they can “win” in some way, no matter which way the stock goes.
If the stock rises, then they can let their put expire worthless and collect profits by selling the underlying stock, minus the premium they paid for the put. If the stock falls, then they can exercise or resell their put for a profit, which could offset the losses from owning the underlying stock.
Writing call options vs. writing put options
Option writing is typically part of a more nuanced strategy than a simple positive or negative bet on a stock. Traders usually sell options to collect income in the form of the premium, to protect their investment in a stock against losses or to try to buy a stock at a bargain price.
In a covered call strategy, a trader sells out-of-the-money calls on a stock they own. If the stock price does not rise to the strike price before expiration — or falls over that time — then the call will expire unexercised and the seller can keep the premium without doing anything. That income may help offset any losses from the underlying stock.
Theoretically, traders can also sell “naked calls” on stocks they don’t own, but doing so is extremely risky.
If a naked call option gets exercised, the seller must be able to immediately purchase the underlying shares at the market price and then sell them to the call buyer at the lower strike price. In other words, a bad naked call trade can leave a seller with less cash and an investment loss at the same time.
As with short selling, this loss is potentially unlimited if the stock keeps rising.
Traders typically sell out-of-the-money puts on stocks they think have potential — stocks they think will rise in the long term. If the stock’s price stays above the strike price until expiration, then the put will expire unexercised and the seller can keep the premium.
If the stock falls below the strike price and the option is exercised, then the seller will be “assigned” or “put” the stock.
That means they’ll have to buy it at the strike price, which will typically be higher than the market price. Getting put isn’t ideal, but if the trader thinks the stock will rise much higher in the long term, then they might still consider the put strike price to be a bargain.
There’s an important caveat to remember about put selling and naked call selling. Both require you to have enough money or margin (money borrowed from your broker) in your account to immediately buy the underlying stock — at the market price in a bad naked call sale or at the strike price in a bad put sale.
As a result, many brokerages require a certain level of margin to write put or call options.
» Dive deeper: Learn the basics of margin trading.
Should you try options trading?
Whether options trading is right for you depends on a variety of factors. These include your level of financial security, your investment goals and your risk tolerance.
Trading options comes with risks, and the Securities and Exchange Commission recommends you understand how options strategies work before investing. If you’re able to pay your bills, you have an emergency fund, you’re saving for retirement and you understand the risks of options trading, feel free to buy or sell some puts and calls with any “extra money” you can afford to lose. You might even win big.
But if you don’t meet those conditions, then trading volatile assets such as options might not be the best idea. It’s a good idea to consult a financial advisor if you’re not sure whether options trading is for you.
» Wondering where to start? Check out our roundup of the best platforms for options trading.
Frequently Asked Questions
How are call and put options taxed?
Call and put option trades are generally opened and closed within a few months. That means, if you're trading options within a taxable brokerage account, profits are generally subject to short-term capital gains tax, and losses are generally deductible as short-term capital losses (up to $3,000 per year, with any additional losses carried over to future years).
If you buy a put or call option, exercise it, and sell the underlying stock, your cost basis is the price of the stock at the time of exercise, plus the purchase price of the option.
Can anyone trade put and call options?
Some brokers place restrictions on options trading, such as only allowing investors with a certain minimum balance to trade options, or requiring them to fill out a questionnaire to assess their options trading knowledge.
