If you are interested in options trading, some terms that you will constantly come across are call and put options. The essential difference between these two terms stems from the fact that one is a buying option for underlying assets, while the other is the option to sell these assets in the derivatives market. 

Warren Buffet often described derivatives as weapons of mass destruction, and Call and Put Options fall under these. 

But when used correctly, these derivatives can help you build wealth and hedge portfolio risks. 

If this sounds interesting to you, let's take a look at what are call and put options, how to use them, the difference between them, and the risks involved.

Call Options vs Put Options - Table of Contents

What is a Call Option?

A call option provides the buyer the right but not the obligation to buy any underlying assets at the strike price on or before the expiry date. 

What is a Put Option?

A put option offers the buyer the right but not the obligation to sell an underlying asset at the strike price before or on the expiry date. 

How Does the Call Option Work?

A call option is a contract that is tied to stocks. You need to pay a fee or premium to get the contract. With that, you now have the right to buy the stock at a set price or strike price at any point until the contract expires. 

But you are not obligated to execute the contract. If the stock price rises enough, then you can sell or execute it to get a profit. If it falls, you can let the contract expire and only lose the premium paid. 

The breakeven point in a call option is the sum of the strike price and its premium. When you have a call option, you can calculate the profits or losses at any given time by subtracting the current price from the breakeven point. 

For example, let's say you are in the bullish section on Apple, and it is trading at $150 per share. Your call option has a strike price of $180 with an expiry date of 1 year. The call option costs a premium of $20 per share. As option contracts cover 100 shares, your total cost is $2000. 

Your breakeven point is $200 as $180+$20 = $200. 

If Apple shares reach a price of $220, your profits are $20 per share, which is a total of $2000. But if your shares go to $175, then you incur a loss of $5 per share. Your maximum potential for loss is the premium of $2000 you paid initially.

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How Does a Put Option Work?

A put option in the contract tried to the stock. You can pay a premium for the contract, giving you the right to sell the stocks when the strike price reaches. Then you can execute the contract at any given point until the expiry date. 

Once the stock price decreases, you can sell your put option for a profit. But if the prices have not dropped enough, you are under no obligation to execute the contract. 

The breakeven point on the put option is the difference in strike price and premium. When you have the put option, you calculate profits or losses by subtracting the breakeven point from the current price. 

Let's take the example; imagine Apple inc trades at $200 per share. You think it is overvalued, so you buy a put option at $150 with an expiry date of 6 months. The premium costs $20 per share, so the total price is $2000 for the contract. 

Your breakeven point is $130, the difference between the $150 strike price and the $20 premium. So, when Apple stocks plummet to $100, you are up $30 a share ($3000 total) on your put option. If the stock does not drop below $130, then all you need to do is let it expire and incur the premium cost.      

What is The Difference Between a Call Option and a Put Option?

Now that we know the basic definitions of call option and put option and how they both work, let's take a look at their differences: 

What are the Risks Involved in Call vs Put Options?

The risk of both call and put options are limited as even when they expire, the stocks become worthless but do not reach the breakeven point. In this case, you only lose the amount paid for the premium. 

You also have the possibility of selling call and put options. This means that another party will pay you a premium amount for the contract. Selling calls and puts is much more riskier than buying them because it carries more significant loss potential. Once the stock price passes the breakeven point and the buyer buys the option, then you must fulfill the contract. 

One of the most significant benefits of buying options is knowing the maximum amount you stand to lose from the beginning. This makes options safer than any other leveraging instrument. But options can be riskier than the buying and selling of stocks. There is a more substantial possibility of leaving with a loss of the premium. To understand options trading, you need to make the following three predictions properly: 

• The direction in the stock moves 
• The amount the stock moves 
• The time period of the stock.

[ Check out Top Options Trading Strategies ]

Conclusion

If you do not make the suitable judgment call, then your options contracts are worthless. But even though there is potential for greater returns with options, they are harder to trade successfully. 

But despite this drawback, options provide ample opportunity to amplify your returns. There are more advanced strategies for serious investors with an extensive portfolio beyond the simple call-and-put options.