When exploring the world of options trading, understanding puts and calls is crucial. These are the basic building blocks of options contracts. In this article, we will delve into what these options mean, the rights and obligations of both buyers and sellers of calls and puts, and provide examples along with visual aids to solidify your knowledge for the SIE® Exam.
What is a Call Option?
A call option gives the buyer the right, but not the obligation, to purchase a specified quantity of an underlying asset at a specified price (known as the strike price) within a specified time period. It is a bet that the underlying asset’s price will rise above the strike price before expiration.
Illustrative Example:
John believes that the stock of ABC Corporation, currently trading at $50, will increase in the next month. He buys a call option with a $55 strike price expiring in one month. If ABC’s stock price rises to $60 before expiration, John can exercise his option to purchase the shares at $55, potentially making a profit, depending on the premium he paid for the option.
graph TD;
A[Buy Call Option] --> B[Underlying Asset Price > Strike Price]
B --> C[Exercise Option for Profit]
What is a Put Option?
In contrast, a put option gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price before the expiration date. Buyers of put options speculate that the asset’s price will decrease.
Illustrative Example:
Jane anticipates that XYZ Corporation’s stock price, currently $75, will decline. She purchases a put option with a $70 strike price expiring in three months. If XYZ’s price falls to $60, Jane can exercise her option to sell XYZ at $70, securing a profit depending on the premium paid.
graph TD;
A[Buy Put Option] --> B[Underlying Asset Price < Strike Price]
B --> C[Exercise Option for Profit]
Rights and Obligations of Buyers and Sellers
Understanding the dynamic between buyers and sellers is crucial in options trading. Each side incurs different rights and obligations:
Call Option:
- Buyer: Gains the right to purchase the underlying asset at the strike price. They pay a premium to the seller for this right.
- Seller (Writer): Obligated to sell the underlying asset at the strike price if the buyer exercises the option. The seller earns the premium.
Put Option:
- Buyer: Gains the right to sell the underlying asset at the strike price. Similarly, they pay a premium to the seller.
- Seller (Writer): Obligated to purchase the underlying asset at the strike price if the buyer exercises the option, earning a premium for this potential obligation.
Summary Points:
- Call Options allow the purchase of an asset at a predetermined price, speculating on the asset’s increase.
- Put Options enable selling an asset at a set price, speculating on the asset’s decrease.
- Buyers have rights, while sellers are obligated under exercised options.
Glossary
- Call Option: A contract giving the buyer the right, not the obligation, to buy an asset at a specified price.
- Put Option: A contract giving the buyer the right, not the obligation, to sell an asset at a specified price.
- Strike Price: The set price at which an option can be exercised.
- Premium: The price paid for purchasing an option.
Additional Resources
Quizzes
Test your understanding with the quizzes below:
### What is a call option?
- [x] It gives the buyer the right to purchase an asset at a specified price.
- [ ] It obligates the buyer to buy an asset regardless of their decision.
- [ ] It gives the buyer the right to sell an asset at a specified price.
- [ ] It obligates the seller to buy the asset at the market price.
> **Explanation:** A call option grants buyers the right, but not the obligation, to purchase an asset at a specified price within a specific timeframe.
### What happens if a put option's underlying asset falls below the strike price?
- [x] The put option may be exercised for a profit.
- [ ] The put option automatically expires.
- [x] The buyer can sell the asset at the strike price.
- [ ] The seller must buy the asset at a premium.
> **Explanation:** If the underlying asset price falls below the strike price, the buyer of a put option can exercise it, selling the asset at the higher strike price for a profit.
### Who is obligated to sell the asset if a call option is exercised?
- [x] The seller (writer) of the call option.
- [ ] The buyer of the call option.
- [ ] The exchange where the trade occurred.
- [ ] The options broker facilitating the transaction.
> **Explanation:** The seller (writer) of a call option is obligated to sell the asset at the strike price if the buyer exercises the option.
### Which scenario is best suited for buying a put option?
- [x] Anticipating that the asset's price will decrease.
- [ ] Expecting the asset's price to significantly increase.
- [ ] Stability in the asset's price.
- [ ] High volatility leading to random price movements.
> **Explanation:** A put option is beneficial when you expect the asset's market price to decline, as it allows selling at a predetermined higher price.
### What profit scenario arises from a call option?
- [x] Underlying asset price exceeds the strike price.
- [ ] Underlying asset price falls below the strike price.
- [x] Exercise the option to purchase at the strike price.
- [ ] Premium paid exceeds the asset price.
> **Explanation:** Profit from a call option arises when the market price exceeds the strike price, allowing for exercise at a lower cost than the asset's market value.
### Upon selling a put option, the seller:
- [x] Agrees to buy the asset if the buyer exercises the option.
- [ ] Agrees to sell the asset if the buyer exercises the option.
- [ ] Gains the right to purchase the asset regardless of the price.
- [ ] Is obligated to sell the asset at market value.
> **Explanation:** Selling a put option obligates the seller to purchase the underlying asset at the strike price if the option is exercised.
### When does exercising a put option generally occur?
- [x] When the asset price falls below the strike price.
- [ ] When the asset price is higher than the strike price.
- [x] To capitalize on a decline in asset price.
- [ ] Before the option premium changes.
> **Explanation:** Exercising a put option is advantageous when the asset's market price is below the strike price, enabling profits from selling at the higher strike price.
### What is the premium in options trading?
- [x] The cost paid by the buyer for the option.
- [ ] The strike price of the option.
- [ ] The market price of the underlying asset.
- [ ] The brokerage fee for executing trades.
> **Explanation:** The premium is the cost incurred by the option buyer for obtaining the rights that the option confers.
### Which is a true statement?
- [x] Buyers of calls seek price increase; buyers of puts seek price decrease.
- [ ] Buyers of puts seek price increase; buyers of calls seek price decrease.
- [ ] Sellers of calls want no price change; sellers of puts want high volatility.
- [ ] Call options and put options are essentially the same.
> **Explanation:** Buyers of call options anticipate asset value increases, while buyers of put options anticipate decreases, aiming to capitalize via option execution.
### Buying a call option implies:
- [x] True
- [ ] False
> **Explanation:** It implies a belief that the underlying asset's price will rise, making the option valuable beyond its premium cost at expiration.
This detailed breakdown aids not only in passing your exam but also deepens your understanding of the options trading landscape, enhance your problem-solving skills, and prepare for practical applications in the investment world.