If you're new to options, you might be wondering, what are puts and calls in options trading?
Understanding the difference between these two types of options is essential.
Luckily, it's not a difficult concept to understand. And we've got you covered in this guide.
Once you've got this down, you'll be ready to start making money trading options...
Options Trading Explained: Calls vs. Puts
Simply put, a call option gives the buyer the right to buy the underlying stock at the option's strike price. This is a great choice if you expect the underlying stock to rise in value over a specific length of time.
Take Veeva Systems Inc. (NYSE: VEEV), for example. As of this writing, shares are trading around $140. A call option with a strike price of $140 (meaning it's at the money) with an expiration date three weeks away is trading at $5.05 per share.
So for about $5 a share, you would get the right to buy Veeva for $140 in the next three weeks.
Obviously if the stock price falls below $140, that's bad for your investment. If it climbs to $145, that's okay: you'd break even, more or less. But if the stock price climbs to $150, then you've got a winning option on your hands.
Of course, you don't buy options by the share. They come in 100-share bundles. So in this scenario, you'd be paying $505 for a bundle of 100 shares.
That $505 gives you control over 100 shares worth roughly $14,000.
Now if the stock price climbs to $150, you've got a potential profit of $495 - a gain of nearly 100%.
You could go through the trouble of exercising the option, buying the 100 shares and selling them for a profit. More likely, you'll simply close out your position by selling your option on the open market. By then, the price of the option will have risen to account for the change in the underlying stock's value.
That's how call options work. You buy a call when you expect the underlying stock to rise in value.
A put option is the exact opposite. Instead of giving you the right to buy the underlying stock, a put option gives you the right to sell the underlying stock.
This is a choice for when you expect the stock to fall in value.
Let's go back to Veeva Systems. A $140 put option for three weeks out is just $3.10. So if the share price falls to $130 before the put option expires, you stand to gain a potential profit of $6.90 per share.
For a contract of 100 shares, that's a $310 investment and a potential return of $1,000 - more than tripling your money in the process.
Call and put options can be great choices when you feel confident a stock is going to move in value in the short term. If you're right, options will compound your winnings far more than simply owning shares in the underlying stock.
This alone is enough to get you started trading call and put options. But if you want to get a little more advanced, keep reading.
Because every time someone buys a call or put option, someone else is selling it.
That someone could be you. And it can be highly profitable, too...
Calls and Puts: Buying and Selling, Opening and Closing
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When you buy a call option, you buy to open. You made a purchase, and your position is open - meaning that movements in the underlying stock price can affect your position.
The same thing is true for buying a put option. Your position is open until you sell it, exercise it, or let it expire.
But on the other side of that trade, someone else sold the buy or call option.
That person, the option writer, is selling to open. They made a sale, and movements in the underlying stock price affects their position.
When you sell an option, you get money up front: the price of the option. From there, you hope the option doesn't move in the buyer's favor so you can keep the money you collected.
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If you sell a call option, you're hoping the price stays the same or goes down. If you sell a put option, you're hoping the price stays the same or goes up.
That way the buyer will simply let the option expire.
If the option moves against you, though, the buyer can force you to sell them shares of the stock (in the case of a call option) or buy shares of the stock from them (in the case of a put option) at an unfavorable price.
In the case of a call option, if you don't own the shares already, that can be costly. That's why some investors use covered calls - in which they already own enough shares to cover the call option if it's exercised - to limit their risk.
If selling options seems too complicated, no worries. After you get a few trades under your belt by buying options, then you might want to look into more advanced strategies that involve different types of positions.
You're now on your way to trading call and put options and making money doing it. Stay tuned to Money Morning for option trading strategies and tips to maximize your money-making potential.
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