Call and put options investopedia


Call and put options are examples of stock derivatives - their value call and put options investopedia derived from the value of the underlying stock. For example, a call option goes up in price when the price of the underlying stock rises. And you don't have to own the stock to profit from the price rise of the stock. A put option goes up in price when the price of the underlying stock goes down. As with a call option, you don't have to own the stock.

But if you do, the put acts as a hedge - as the stock price goes down, the value of the put goes up so you are hedged against the downside. You make money on options if your bet on the direction of price movement of the underlying stock is correct. If not, you'll probably loose most or all the money you paid for the option. Options are very sensitive to changes in the price of the underlying stocks.

Like gambling you can make or lose money very quickly. Because option prices change quite rapidly, owning them requires that you spend a significant amount of time monitoring price changes in the stock and the option. And if you're wrong about the price call and put options investopedia, be prepared to lose all or a significant portion of the money you paid for the options. A call is a contract that gives the owner the right, but not the obligation, to buy shares of a stock at a fixed price, called the strike price, on or before the options expiration date.

If the value of the stock goes down, the price of the option goes down, and you could hold it or sell it at a loss. The price that you pay for a call option depends on many factors two of which include: See the following videos: If you own a stock, call and put options investopedia may buy a put as a form of insurance.

If the stock falls in price, the put rises in price and helps offset the paper decline in the underlying stock. If you don't own the stock but think it will go down in price, you buy the put to profit from the decline in price of the stock. If the stock price declines, the value of the put rises and you would sell the put for a profit. If the stock increases in price you may sell the put for a loss.

A put option is a contract that gives you the right, but not the obligation, to sell a stock at a preset price. The price that you pay for a put option depends the duration of the contract the longer the duration, the more you pay and how far the current price of the stock is from the strike price of the contract.

Put buying is different from selling short. With a put option your only liability is the price you paid for the put. With a short sale, you have an unlimited downside liability if the stock goes up. Also, the proceeds from selling short are in a margin account so you have to pay interest and meet margin requirements. Buying puts is a more conservative call and put options investopedia of call and put options investopedia on a stock declining in price.

Selling a Call For every buyer of a call there must be a seller, who assumes that the stock price will remain flat or go down. The seller collects the purchase price of the option but has the obligation to sell shares of the stock if the buyer decides to exercise the option. If the seller gets called - he must sell the stock. If the stock continues to appreciate in price after the stock is sold, call and put options investopedia seller looses the future price gain. In most cases you must own shares of the stock for each contract you sell - this is called a covered call.

Therefore, if your stock gets called away, you have the shares in your account. You can sell covered calls to generate a stream of income. If the stock price does not rise enough during the period of the contract, you won't get called and won't have to sell the stock so you keep the money you received when you sold the call and put options investopedia. If your broker lets you, you may sell "uncovered "or "naked" calls in a margin account.

This practice lets you sell calls when you don't own the stock. If you get called, you must buy the stock at its current market value to cover the call even when the market price is higher than the strike price of the option. Like any margin account transaction, you must execute the transaction immediately.

The seller of a put collects the purchase price of the option from the buyer of the put. The seller has the call and put options investopedia to buy shares at the strike price regardless of the market value of the underlying stock.

So if the put buyer decides to exercise the put contract, the seller of the put has to buy the shares at the strike price no matter the current market value of the stock.

When you sell a put, you want the price of the call and put options investopedia to go up so you don't get the stock put to you - buy the stock for more than it's worth. Selling a put places the money you receive in a margin account so you pay interest on the proceeds until the put contract is closed.

If you don't have the financial resources to cover the obligation of buying the stock from the buyer of the put, you sold "naked puts". It tells about a trader who sold naked puts and experienced financial ruin. It was an unhedged bet, or what was called on Wall Street a "naked put" On October 27,the market plummeted seven per cent, and Niederhoffer had to produce huge amounts of cash to back up all the options he'd sold at pre-crash strike prices.

He ran through a hundred and thirty call and put options investopedia dollars - his cash reserves, his savings, his other stocks-and when his broker came and asked for still more he didn't have it. In a day, one of the most successful hedge funds in America was wiped out. Niederhoffer was forced to shut down his firm. He had to mortgage his house. He had to borrow money from his children. He had to call Sotheby's and sell his prized silver collection Use calls and puts judiciously.

If you're right, you can make quick money. If you're wrong, you can lose part or all of your investment very quickly. Do not sell "naked" options. You may be inviting a financial disaster.

Knowledgeable, experienced investors may want to sell covered calls and puts to collect other peoples money. Because the price of options can change very quickly and dramatically, you must continually watch their price movement.

If you not prepared to do so, don't call and put options investopedia or sell options. Alternative Actions for the Call Buyer. Alternative Actions for the Put Buyer. Alternative Actions for the Call Seller. Alternative Actions for the Put Seller. What the call buyer may do. Exercise call option if the stock price rises above the strike price.

Buy shares at strike price, which is less than market price buy stock for less than it's worth. Exercise option if the stock price declines. Sell shares at strike price, which is more than market price sell stock for more than it's worth. Put buyer must own shares to sell. Can already own them or buy them at market price, which call and put options investopedia less than strike price.

What the call seller may do. Sell shares at the strike price to the call buyer if the call buyer exercises the call option. If the call seller already has shares in his account, they are sold to the buyer at the strike call and put options investopedia. If the call seller does not have shares, he must buy the shares on the open market at a price greater than the strike price. What the put seller must do. Buy shares from the put buyer if the put buyer exercises the put option.

If the put seller already has money in his account to buy the stock, the put option is covered. If the seller does not have money to buy the stock, call and put options investopedia put option is naked. The put seller must come up with money to buy the stock.

The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast - when you expect the underlying stock price or index level to change very little over the life of the options. A butterfly can be implemented using either call or put options. For simplicity, the following explanation discusses the strategy using call options.

A long call butterfly spread consists of three legs with a total of four options: All the calls have the same expiration, and the middle strike is halfway between the lower and the higher call and put options investopedia.

The position is considered "long" because it requires a net cash outlay to initiate. When a butterfly spread is implemented call and put options investopedia, the potential gain is higher than the potential loss, but both the potential gain and loss will be limited. The total cost of a long butterfly spread is calculated by multiplying the net debit cost of the strategy call and put options investopedia the number of shares each contract represents.

A butterfly will call and put options investopedia at expiration if the price of the underlying is equal to one of two values. The first break-even value is calculated by adding the net debit to the lowest strike price.

The second break-even value is calculated by subtracting the net debit from the highest strike price. The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices.

The maximum risk is limited to the net debit paid for the position. Butterfly spreads achieve their maxim profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration. As with all advanced option strategies, butterfly spreads can be broken down into less complex components. The long call butterfly spread has two parts, a bull call spread and a bear call spread.

Please note that this is a three-legged trade, and there will be a commission charged for each leg of the trade. This profit and loss graph allows us to easily see the break-even points, maximum profit and loss potential at expiration in dollar terms. The calculations are presented below. The two break-even points occur when the underlying equals On the graph these two points turn out to be where the profit and loss line crosses the x-axis.

The maximum profit can only be reached if the DJX is equal to the middle strike 75 on expiration. The maximum loss, in this example, results if the DJX is below the lower strike 72 or above the higher strike 78 on expiration. By looking at the components of the total position, it call and put options investopedia easy to see the two spreads that make up the butterfly. A long butterfly spread is used by investors who forecast a narrow trading range for the underlying security, and who call and put options investopedia not comfortable with the unlimited risk that is involved with being short a straddle.

The long butterfly is a strategy that takes call and put options investopedia of the time premium erosion of an option contract, but still allows the investor to have a limited and known risk. An expiration profit and loss graph for this strategy is displayed below.

A short strangle gives you the obligation to buy the stock at strike price A and the obligation to sell the stock at strike price B if the options are assigned. You are predicting the stock price will remain somewhere between strike A and strike B, and the options you sell will expire worthless. By selling two options, you significantly increase the income you would have achieved from selling a put or a call alone.

But that comes at a cost. You have unlimited risk on the upside and substantial downside risk. To avoid being exposed to such risk, you may wish to consider using an iron condor instead. Like the short straddleadvanced traders might run this strategy to take advantage of a possible decrease in implied volatility. If implied volatility is abnormally high for no apparent reason, the call and put may be overvalued. After the sale, the idea is to wait for volatility to drop and close the position at a profit.

You may wish to consider ensuring that strike A and strike B are one standard deviation or more away from the stock price at initiation. That will increase your probability of success. However, the further out-of-the-money the strike prices are, the lower the net credit received will be from this strategy.

This strategy is only for the most advanced traders who like to live dangerously and watch their accounts constantly. You are anticipating minimal movement on the stock. If the stock goes down, your losses may be substantial but limited to strike A minus the net credit received. Margin requirement is the short call or short put requirement whichever is greaterplus the premium received from the other side.

The net credit received from establishing the short strangle may be applied to the initial margin requirement. After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase or decrease in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis.

For this strategy, time decay is your best friend. It works doubly in your favor, eroding the price of both options you sold. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back. After the strategy is established, you really want implied volatility to decrease.

An increase in implied volatility is dangerous because it works doubly against you by increasing the price of both options you sold.

That means if you wish to close your position prior to expiration, it will be more expensive to buy back those options. An increase in implied volatility also suggests an increased possibility of a price swing, whereas you want the stock price to remain stable between strike A and strike B. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options.

Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risksand may result in complex tax treatments.

Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract.

There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.

System response and access times may vary due to market conditions, system performance, and other factors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy.

The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results.

All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between. The Strategy A short strangle gives you the obligation to buy the stock at strike price A and the obligation to sell the stock at strike price B if the options are assigned.

Options Guy's Tip You may wish to consider ensuring that strike A and strike B are one standard deviation or more away from the stock price at initiation. Both options have the same expiration month. When to Run It You are anticipating minimal movement on the stock.

Break-even at Expiration There are two break-even points: Strike A minus the net credit received. Strike B plus the net credit received. The Sweet Spot You want the stock at or between strikes A and B at expiration, so the options expire worthless.

Maximum Potential Profit Potential profit is limited to the net credit received. Maximum Potential Loss If the stock goes up, your losses could be theoretically unlimited. Ally Invest Margin Requirement Margin requirement is the short call or short put requirement whichever is greaterplus the premium received from the other side. As Time Goes By For this strategy, time decay is your best friend.

Implied Volatility After the strategy is established, you really want implied volatility to decrease. Use the Probability Calculator to verify that both the call and put you sell are about one standard deviation out-of-the-money.