Call Option
A call option is the right, but not an obligation to buy something at a fixed price – the strike price at anytime within the specified time period.
In this definition, the “something” is the underlying which the investor has the right to buy or sell. The underlying is usually either an exchange traded stock or a commodity. Note that an option gives the buyer the right to buy or sell the underlying contract at a predetermined price. The specific price at which the underlying can be bought or sold is referred to as the strike price or exercise price of the option.
Options only have a limited life-span. In the above definition of an option the buyer of an option can exercise the right within a specified time period. The exercise period of the option specifies when the option expires and can no longer be traded. The exact date in which the option expires is set by the exchanges and differs from one exchange to another. Different month options are entirely different instruments, so a June option is a separate and distinct contract from a July option.
Investors buy call options if they think that the price of the underlying will go up and buy put options if they think the price of the underlying will go down.
The price paid for acquiring the right to buy is called the call option premium. Assume that Microsoft shares are traded on the Exchange at $38.75 on 25th Feb X1. Assuming that the next expiry period is 15th Mar X1, the call option premium having an exercise price of $40 may be priced at $1.25. This means that the buyer of the option can exercise the right to buy the shares at a price of $40 at any time on or before 15th Mar X1. Hence if the price of Microsoft increases beyond $40 then he will stand to gain to the extent the price is over and above the premium paid by him amounting to $1.25 per share. However if the price of Microsoft stays below $40 and even if it drops down substantially to say $30 per share, the buyer of the option would stand to lose only the option premium paid by him already.
Whether the investor has the right to buy or to sell depends on which type of option the investor buys. The purchaser of a call option has the right to buy the underlying asset. The purchaser of a put option has the right to sell the underlying asset. Note that puts and calls are mutually exclusive. A call option does not offset a put option and vice versa.
Example: In the National Stock Exchange, India, the quotes are available for the current month, near month and far month. For example, when investors trade in early May, they get quotes for May, June and July. The settlement period is the last Thursday of the relevant month. So, if an investor buys 1 lot of May-X1 – Rs.600 strike price, call option of ABB at a premium of Rs.6, it means that the investor can exercise the option before the settlement date for May-X1 viz., the last Thursday in May-X1.
Put Option
A put option is the right, but not an obligation to sell something at a fixed price – the strike price at anytime within the specified time period.
The price paid for acquiring the right to sell is called the put option premium. Assume that Microsoft shares are traded on the Exchange at $38.75 on 25th Feb X1. Assuming that the next expiry period is 15th Mar X1, the put option premium having an exercise price of $38 may be priced at $1.00. This means that the buyer of the option can exercise the right to sell the shares at a price of $38 at any time on or before 15th Mar X1. Hence if the price of Microsoft goes below $38 then the investor will stand to gain to the extent the price goes down over and above the premium paid amounting to $1.00 per share. However if the price of Microsoft surges above $38 and even if it rises up substantially to say $50 per share, the buyer of the option would stand to lose only the option premium paid by him already.
When the investor buys a put, then the investor has the right to sell the underlying. Note that the investor is dealing with different instruments here. The investor is buying a put instrument that gives the right to sell a different and distinct instrument which is the underlying asset.
