Derivatives · Intermediate · 5 min

Calls and puts

You can explain what calls and puts give their buyers and sellers, calculate the result at expiry, and name where the losses can be largest.

A right, not a duty

Imagine paying a small fee today for the right to buy a share at today's price, at any time over the next three months. If the share rises, you use the right. If it falls, you let it go and lose only the fee.

That is a call option. Its mirror image, the right to sell, is a put. Options are among the oldest derivatives, and their logic is simple once you see it at expiry. This lesson covers both.

Call to buy, put to sell

The SEC describes the basic terms:

A call option gives the buyer the right to buy the underlying at the strike price until expiry. The seller must sell if the buyer exercises.
A put option gives the buyer the right to sell the underlying at the strike price until expiry. The seller must buy if the buyer exercises.
The strike price is the price at which the underlying can be bought or sold.
The option premium is the price of the option, paid up front by the buyer to the seller. It is not refundable.

US stock options usually cover 100 shares, so premiums are quoted per share and multiplied by 100.

At expiry, a call is worth the amount by which the underlying is above the strike, or nothing. A put is worth the amount by which the underlying is below the strike, or nothing.

The risks are lopsided:

Buyers can lose at most the premium. In return, they need the underlying to move far enough, soon enough, to cover it.
Sellers, also called writers, keep the premium if the option expires worthless, but take on the obligation. The SEC warns that writers face more risk. A seller of a call that is not covered by owned shares can face unlimited losses.

Strike 70, premium 2.20

Building on an example the SEC uses: an investor buys a call with a strike of 70 for a premium of 2.20 per share, on 100 shares, so 220 in total.

The stock ends at 80. The call is worth 80 − 70 = 10 per share, 1,000 in total. Profit: 1,000 − 220 = 780.
The stock ends at 72.20. The call is worth 2.20. The buyer breaks even.
The stock ends below 70. The call expires worthless. The buyer loses the 220 premium.

The seller of that call earns the 220 if the stock stays below 70, and loses 780 if it ends at 80. If it rose to 120, the seller's loss would be 4,780.

Common mistakes

Seeing a cheap option as low risk. The whole premium can be lost.
Ignoring the breakeven. The underlying must pass the strike plus the premium.
Selling options for the premium without a plan. Losses can be large.
Forgetting the multiplier. A premium of 2.20 usually means 220 per contract.

The takeaway

A call is the right to buy, a put the right to sell, at the strike price. Buyers can lose the premium, sellers can lose far more.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the price at which this call buyer starts to make a profit at expiry.

Tap the chart.

Breakeven = strike + premium = 70 + 2.20 = 72.20. Below that, the call loses money.
2In the SEC's example, an investor buys a 70 call for 2.20 per share, on 100 shares. The stock ends below 70. What is the loss?

The call expires worthless, and the buyer loses the premium paid: 2.20 × 100 = 220.
3What does a put option give its buyer?

Puts gain value when the underlying falls below the strike.
4Who carries the larger potential loss on a call option?

The SEC notes that option writers face more risk, and some can face unlimited losses.

of 4 correct.