Whenever someone new learns about options trading, the first and definitely most interesting terms that comes up are "Put and Call Options". This definitely throws alot of options beginners off because unlike in stock trading where you simply buy and sell stocks and in futures trading where you simply buy and sell futures contracts, in options trading, you don't just simply buy and sell options because suddenly, there are actually two kinds of options! Put Options and Call Options! Why the need for Put and Call Options? Why can't options be like futures or stocks where you simply buy (or go "Long") to invest in an upwards move and simply short (or "sell") to invest in a downwards move? This is exactly where the magic of options trading lies! Because you can actually go "long" and "short" on BOTH Put and Call Options! Why the complexity? Why make options trading so complex?
This free options trading tutorial will explain what Put and Call Options are, the necessity for both Call and Put Options and how both kind of options combine to produce some really interesting investment opportunities.
Put and Call Options - What Are Put and Call Options?
Put Options and Call Options are two different kinds of options contracts that are traded in what is known as "Options Trading". Yes, unlike futures trading or stock trading where you buy and sell only 1 kind of financial instrument (you only buy or sell a stock or long or short a futures contract), there are actually 2 in options trading, Put options and Call options. Put options are options that you buy in order to make a leveraged profit when the price of the underlying stock goes downwards and call options are options that you buy in order to make a leveraged profit when the price of the underlying stock goes upwards.
So why is it necessary to have two different kinds of options? Why can't it be like futures trading where you simply have one option and you go long to make a leverage profit to upside and go short to make a leverage profit to downside?
Put Options and Call Options are like the positive and negative polarities of a battery or the yin and yang in ancient asian teachings or the 1 and 0 in computer programming. And exactly like the 1s and 0s in computer programming having infinite combinations to create almost any kind of computer programs, put and call options are the 1s and 0s of options trading capable of infinite combinations to create almost any kind of options strategies. This is why Put and Call Options are the basic building blocks of options trading.
Put and Call Options - The 4 Basic Building Blocks of Options Trading
Do you wish to create an investment opportunity that profits no matter if the underlying stock goes Upwards, Downwards AND Sideways, in every direction? Wow... is that even legal? Sounds too good to be true! But its true (and legal!) when you start to combine put and call options creatively.
The real magic of options trading lies not in trading call options or put options individually but in the creative combination of both put and call options to create what is known as "Options Strategies" or "Options Positions". Options strategies are the true magic of options trading and why having both put and call options is so important in options trading. While buying call options allows you to profit when the price of the underlying stock goes upwards annd buyinng put options allows you to profit when the price of the underlying stock goes downwards, optionns strategies allow you to profit in multiple directions all at once. Through the creative combination of put and call options, you could profit no matter if the price of the underlying stock breaks out upwards OR downwards, without having to make a precise guess. This is really as close to financial alchemy you can get. In fact, you could create options strategies that profit no matter if the price of the underlying stock breaks out upwards, downwards or even remain sideways! Yes, the creative use of both put and call options allows you to make a profit even if the price of the underlying stock doesn't move at all!
This is why put and call options are the basic building blocks of options strategies, capable of creating literally unlimited number of combinations. This is possible due to three main characteristics off put and call options unfound in other investment instruments such as stocks and futures; Limited risk with unlimited profit, multiple strike prices and being able to take both long and short side of each options contract. ( To learn more about how exactly put and call options work with layman examples and simple to understand concept, please read our Options Trading For Dummies.)
Buying call options (long call options) gives you unlimited profit potential (as long as the price of the underlying stock keeps going upwards) with limited risk (you can only lose up to the amount of money you used towards its purchase) while shorting call options gives you limited profit potential (profiting from the amount of money made through selling the call options) and unlimited risk (you keep losing money for as long as the price of the stock keeps dropping). Buying put options (long put options) gives you unlimited profit potential (as long as the price of the underlying stock keeps going downwards) with limited risk (you can only lose up to the amount of money used towards its purchase). Furthermore, you could buy or short call and/or put options across a multitude of strike prices! Yes, there isn't just one call option or one put option to trade on each stock, there can be tens of different strike prices to choose from for both put and call options. As such, there can be HUNDREDS of options available for trading on each optionable stock across a multitude of different expiration months.(Check out more than a hundred options strategies at: Options Strategy Library.)
Due to these characteristics it becomes meaningful and completely legal to even buy and short put or call options of different strike prices of the same month on the same stock whereas in stock trading or futures trading, taking both long and short position of the same month only end up with no positions at all. Doing so opens up a whole new world of endless possibilities and combinations. Just like Lego blocks, you could literally create every and any options strategies of any payout profile that you wish. (Read the full tutorial on Put Options and Call Options)
As such, the 4 basic building blocks of options trading derived from Put and Call Options are; Long Call, Short Call, Long Put and Short Put. The following picture illustrates how from just call option and put option, endless combinations or options strategies can be created.
As you see above, when you buy both put and call options (yes, it is perfectly legal to buy both put and call options at the same time), you result in an options strategy that profits no matter if the price of the stock goes upwards or downwards due to put and call options having unlimited profit potential with limited loss potential. This is known as a "Long Straddle". In a Long Straddle, when the price of the stock goes upwards, the value of the put options gradually go down to $0 (limited risk) while the value of the call options continue upwards as long as the price of the stock continues upwards (unlimited profit), coming to a point where the profit on the call options make up for the loss of the value on the put options and more. Vice versa is true. Just this one simple options strategy involving the purchase of both put and call options, you create an options strategy that allows you to do something no other financial instruments are capable; the ability to profit no matter if the price of the underlying stock goes upwards or downwards.
If you think going long on both put and call options is too expensive, you could combine the above with the shorting of a higher strike price call option and a lower strike price put option to create what is known as a Reverse Iron Butterfly Spread which is capable of furthering the return on investment (ROI) of the Long Straddle above by lowering the cost of the position when the price of the underlying stock is not expected to exceed a certain higher or lower price on the breakout.
If you think a stock of $50 is going to move upwards within a month, you could buy a call option on the $50 strike price in order to profit from that move. However, you think it is not going to exceed $55 by the end of the month. As such, you decided to also sell the $55 strike price call option in order to lower the price of the position from the income from the sale partially offsetting the cost of buying the $50 call options, thereby also improving the ROI of the trade. This is known as a "Bull Call Spread".
Do you see how through the use of put and call options, you can literally create positions that confirms to any and every specific investment outlook that you have? This is exactly why options trading is so powerful and why it is the most versatile investment instrument in the world today. In fact, Selling Put Options alone could also lead to some interesting opportunities.
What Put and Call Options Look Like
Here is a short video showing you what put and call options look like in a trading account.
Put and Call Options - Conclusion
While Put and Call Options when traded individually are great leverage tools to use for directional trading, the real intention behind their existence is for use in combination to form options strategies that are capable of profiting in more directions than one, increasing ROI and more. Without the need to form options strategies, if options trading is only about leveraged directional trading, there will be no need for put and call options, just buying and shorting a single option will do. To learn more about how exactly put and call options work with layman examples and simple to understand concept, please read our Options Trading For Dummies.
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