What are put and call options?

  1. These options are contracts or agreements made between two individuals. One party the purchaser is said to own the contract or be long in that contract. To purchase the contract, the buyer pays a premium to the writer. In turn the owner is allowed discretion about execution of the agreement. If it is to the owner's advantage to execute the contract he will. Conversely, if it is not in the owner's best interest to execute the contract he need not. Clearly the writer or seller of option contracts has a different responsibility. The writer must do what the buyer requests. The inducement for the writer is merely receipt of the premium. Option contracts normally have a finite life known as their maturity after which they expire. The maturity date is also known as the expiry date. The precise time when these contracts can be exercised varies according to the terms of the contract. Some contracts can be exercised anytime from their creation until their expiration. These are known as American options. Other contracts can only be exercised upon their expiration date. These are known as European options. Yet other contracts allow for exercise somewhere in the middle of the time between when they were created and when they expire. Such options which can be exercised somewhere in the middle between the times when American and European options can be exercised are know as Bermuda options. Just as Bermuda lies between America and Europe, Bermuda options can be exercised sometime in the middle. Other colorful terms are often applied to options. For example Asian options are exercisable at a rate that existed during their life. Although a rich assortment of option contracts with terms ranging from simple to exotic exist, the two most simple building blocks which can be used to create most of the others are puts and calls. In fact it is even possible to demonstrate the equivalence of puts and calls. Lets begin our look at these contracts with an examination of these two basic items.
    1. Puts entitle owners to sell a prescribed quantity of something that is well defined, typically a security, at a prescribed price known as the exercise or strike price during a prescribed interval. The typical prescribed quantity of a put is one round lot or 100 shares of stock. Option contracts traded in the United States on an organized exchange have exercise prices set at relatively round prices. For example strike prices might be set at $20, $25, and $30 per share. The purpose of doing this is to restrict the potential number of contracts with unique terms so that contracts will be fungible and thus readily traded in a secondary market.
    2. Calls entitle owners to buy a prescribed quantity of something that is well defined, typically a security, at a prescribed price known as the exercise or strike price during a prescribed interval. The various other characteristics of calls are consistent with those for puts.

What are puts and calls worth?

# Since calls are more prevalent than puts, lets look at them first. Just as other assets are valued, calls are worth what a willing buyer pays to a willing seller. However, calls have an additional feature that guides market participants. When exercised, calls have a precise value that derives from its relationship to its underlying security. If the market price of the underlying security is S and the exercise of a call option is X, the call will be worth the greater of S - X or 0. The relative levels of the market price and the exercise of a call define it as being in-the-money when the market is above the exercise. Thus, a call that is in-the-money can be exercised profitably. Conversely, a call is out-of-the-money when its exercise is above the market. Owners of a call option that is out-of-the-money would not exercise their contract, even if it is about to expire. It would be cheaper and thus better to buy the underlying security in the open market. Consequently, out-of-the-money calls expire worthless. If the underlying asset's market price exactly equals the exercise price, the option is at-the-money. Since exercising at-the-money options would generate no benefit, these also expire worthless. Actually, for a call owner to profit through ownership of a call, the underlying asset's price must exceed the exercise price by an amount to allow coverage of the premium that was paid. If a call is about to expire and the underlying asset price is above the exercise but below the break-even price that covers the premium, its owner may exercise to reduce losses.

How are puts and calls used?

There are three ways to take advantage of puts and calls. One, if you have a conviction about significant price changes for a security, buying a put or a call can be vastly superior to buying the stock or selling it short. Second, if you wish to engage in certain transactions it can be more profitable to accomplish that transaction with derivatives. Third, people with substantial portfolios can put their portfolios to work doing double duty by earning normal returns plus earning income on covered transactions. Each of these techniques are elaborated below.


Security market participants can fall into several different categories. The most prevalent is likely to be investors. These participants own securities for the long-term purpose of earning a modest rate of return. Obviously, ownership of any security produces risk. Presumably the quantity of risk associated with investing is modest. Those market participants willing to take extra risk engage in a practice of speculation. Presumably that additional risk justifies and potentially rewards speculators with substantial additional return.

Enhancing trades

Many commonly practiced trading techniques have corresponding alternatives that sometimes offer benefits. To take advantage of these alternate practices, one must possess knowledge that may not be widely available.

Portfolio return improvements

Passive portfolios earn returns for their owners in two dominant ways. Dividend payments may periodically be declared by a firm's board of directors. Capital gains the second benefit to share holders result when owned securities appreciate in price. A third benefit available to substantial shareholders is control of the corporation. Only a limited number of shareholders likely have an adequate fraction of the corporate ownership to avail themselves of this benefit. Such substantial share holders may appoint themselves to high ranking positions within a firm and thereby obtain salary benefits.

What advantages do using puts and calls provide?

Options for everyday tasks

sources of information

Zero cost collars