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A call option allows you to purchase an underlying stock, while a put option will enable you to sell it. If you buy a call, you want to make a profit from rising stock values. However, a put option will allow you to make a profit when the stock decreases in value.
When should you use each one?
With a call option, you should buy it when you expect the price of a stock to go up before the expiration date of the call. With a put option, you should buy it when you expect the stock price to go down before the put’s expiration.
Ideally you will only buy calls or puts if you were to KNOW the direction a stock would go but if you have inside information about a stock and trade on it then that would be considered insider trading which is illegal.
However if you believe that a certain company will have a good or bad quarter or year based on economic or company trends then you can make an educated guess (or investment) by purchasing a call or put depending on if you believe the stock price will go up or down.
If you believe a stock will go up, then buy a call. If you believe it will go down, then buy a put.
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The Two Types of Options
There are two main types of options- the call and the put option. It helps if you think of them as opposites. Doing so also makes it easier to determine when to buy them.
Call options allow you to buy an asset at a set price and before a set time (the expiration date). Puts are the opposite- they allow you to sell the asset at a fixed price before a set time.
In short, these options give you the right to buy or sell. Although, you only have to take action if you want to. You must understand the strike price before you start working with options.
Know the Risks
Stock prices have the potential to rise infinitely, although they can only drop to a certain amount. That means the value of an option has the potential to increase infinitely.
For both calls and puts, the maximum potential loss is the premium you paid to buy the option originally.
However, if the stock goes below the strike price on the expiration date, all of your call options expire and are worthless. If the stock goes above the strike price of your put option then it will expire worthless as well.
Understanding Strike Price
The strike price linked to your option is the price you can exercise a put or call option at. You need to pick the strike price according to your investment strategy.
It will significantly impact the way your trade goes, including your profit. However, there is some risk associated with it.
When a stock reaches a strike price, it might not be worth holding onto until the expiration date. The better option could be to sell the option and secure that profit.
For example, if you believe a stock will go up to $30 a share and it does so a few weeks or months before expiration, then you can sell that option for a nice profit rather than having to exercise it or wait for the expiration date.
Often locking in profits early is a good idea as it will allow you to get out of winning option trades and help you avoid the possibility of the trade turning around and going against you.
You can also exercise your right to buy or sell at any time. However, you must do so before the expiration date of your option.
So if you really wanted to buy the stock and you think it will continue to rise then you can exercise the option before the expiration date if you choose to.s
When Should You Buy Call Options?
Call options allow for the purchase of shares of a stock at a specific strike price. It would be best to purchase call options when you expect the stock’s value to go up.
In short, a call allows you to profit from the market rising.
Call options allow you to get the most from a stock that is increasing in value. As long as the stock increases in value quickly or rises above the strike price by expiration you can have a nice profit.
Calls are cheaper than buying a stock outright as well. So if you firmly believe that a specific stock (or index) will rise in price then you can buy a call against it.
When Should You Buy Put Options?
Remember, a put works differently than a call- they’re two opposite options. You want to consider puts when you think the underlying stock or index will decline in value.
When you use a put, you’re looking to make money from a short sale.
It would be best if you bought put options when you think the value of the underlying stock will drop. You want to do this if you believe the price will go down before the expiration date.
You can then sell the stock and profit from the difference- just like with short selling or you can simply sell the put on the open market without ever taking possession of the stock.
Overall, you buy put options when you believe the value of the underlying stock is going to go lower. You can always sell when the option is above its market price.
As with calls, your maximum amount of money at risk is the premium that you paid for the put.
Selling or Exercising Your Call/Put Options
Many new investors wonder whether it’s better to exercise or sell their options. Most option buyers recommend that you sell them to make a profit. While you always have the right to exercise the option, it’s not always the best idea.
For most investors it is better to simply sell the put or call on the open market rather than exercising the option. Most brokerages have additional fees when exercising options so selling it on the market and taking your profits is better in almost every situation.
According to Investopedia, exercising an option is buying or selling the underlying security at the strike price. You can do this on or before the expiration date of the option.
It’s important to consider what you want to do with the option after buying it. You only have until the expiration to sell or exercise the option. As a final choice, you can always hold the option until it expires and then exercise it.
This strategy is suitable for when the option is “in the money.”
To summarize, there are two main types of options. The first is the call; you want to buy this when you expect the market price to go up.
The second is the put; you buy these options when you believe the price of a stock will drop in the future. To keep it simple, you can think of them as opposites.
Overall, you have plenty of strategies that you can take when it comes to options. I recommend learning as much about them as possible before you make a move.
You want to make informed choices that will hopefully earn you a profit from the market.