Lesson 2 – Call & Put Options

An introduction to the Call and Put options were given within the previous lesson. Now we will be looking into the detailed elaborations of what these concepts are and explain them fully to you.

Here we will first compare the difference between Call and Put options.  Then we will discuss why traders use them while explaining the difference between Takers and Writers. Then the strategies within the use of Options will be elaborated as well.

We learned from lesson one that Option is the ‘right to buy or sell the underlying at a set price. However, there is no obligation to do so, either on or even before a set date.

The two specified option types are;

1. Call Option – the right attached without the obligation to buy the underlying at a set price, however, there is no obligation to do so, either on or even before a set date
2. Put Option – the right to sell the underlying at a set price, however, there is no obligation to do so, either on or even before a set date

An Option is a contract between two parties known as Taker and Writer. We will refer to ETO’s (Exchange Traded Options) throughout the entire course. ETO’s have been standardized by Exchange.

Components of Options include

• Underlying: It can be anything like a commodity, bonds, stock, bond, index, or currency.

• Premium: The cost of purchase of an option contract

• Strike price: The set price which the underlying is determined to exchange hands at

• Expiry date: the future date at which the contract will end

• Contract size: in Australia, a standardized contract size is at 1 option contract = 100 shares

• Exercise Style: 2 options styles available, namely;

1) American

2) European

Call options provide the right to buy shares.  This purchase would bolt the right to buy shares and, thus, price setting in the future.

With an increase in the underlying price, the payment (premium price) required to be paid to buy a call option increases. This allows you to use it as an alternative process to directly trading the underlying, by allowing you to transact in and out of Call options rather than waiting for expiry. A fact to keep a note of is that there would be a lesser requirement of capital as premium is discounted from the actual price of underlying.

Thus it would allow call options to be used as an income generation mechanism through Option writing against the shares you own or buy.

When looking at an example as follows,

Provided that you believe that BHP is expected to rise. You have the option of buying the BHP shares, thus gaining a profit from the rise in underlying, else you are able to purchase a BHP Call option. Using an option will allow you the benefit gained from the rise in underlying, yet there is no requirement to uncover the same capital for the trade.

This illustration states that if we had purchased BHP @ $57.11 and then sold it at $77.20, the profit would be $20.09. Assuming the purchase was 200 shares, this would require an original capital of $11,422 and will thereby gain a profit of $4,018, or 35%

For the same Option, for the command of the same number of shares (remember that 1 Option contract is equivalent to 100 shares), the requirement would be $1,140 of starting capital, further making a profit of $2,190. The percentage difference between the use of stocks or options is quite a substantial one.

Income generation is also a use of Call options. This knowledge is required for the introduction to the writing options concept. This will later be discussed in detail within the explanations of strategies.

The writer receives the premium for the option sale as the Taker pays the premium for the purchase of the Option. Thus a call option writer can be denoted as a person obliged to the sale of the underlying at a decided price, on or before a date aforementioned, in the future. This allows the Taker an obligation less right for the purchase of shares. The writer, however, is given the obligation to the sale of shares, provided that the taker exercises contract.

In the assigning or the exercising of the call option, the contract determines the rights to be exercised by the Taker. This assures that the strike price is to be lower or at an equivalent rate to the underlying price.

The below examples have been brought forth under the assumption that this is the date of expiration:

TLS trades at $3.50. The $4.00 Call strike is thus beyond the share price. Therefore, the expiration of the call option will be worthless.

WOW, on the other hand, is trading at $28.90. The $25.00 Call strike is beneath the actual share price. Still, the call option is to be exercised as the Taker has the right to purchase WOW shares at $25. Thus the writer is required to sell shares to the Taker at $25.

The discussion of what ATM, ITM, and OTM strike levels within the scope of Call options. The introduction was provided within Lesson 1, let us look at it in more detail;

The rate closest to the current share price is the ATM strike price. Therefore, the ATM Strike level would be at $27.00 if the share price was at $27.00. The share price may differ to the strike price at times and need not be exact. This scenario is known as Near The Money (NTM). Thus both instances of ATM/NTM speak of strike levels most close to the price of the stock.

On the other hand, the ITM strike prices are the rates that are lower than the current share rates, and they have Intrinsic Value.  This is the value known to be the difference in the current share price and ITM strike price. This would be discussed in a detailed perspective within the Option Pricing lesson.

The OTM strike prices for Call options have no Intrinsic Value and further form the strike prices higher than the current share price.

OTM strike prices will convert to ATM and thereafter ITM with increases in the share price.  This means that prior ITM strike prices come to be additionally ITM. Alternatively, with a fall in share price, the ITM strike prices will convert to ATM and OTM thereafter. This means that prior OTM strike prices come to be additionally OTM.

The key to the impact on the Risk of the strategy adopted by yourself would heavily depend on the understanding that you have regarding the differences within the ATM, OTM, and ITM.

When comparing with the Call options, the Put options create the right without the commitment of sale of the underlying at a given price on or before a set date. These may be used as a means of protecting shares or used as income generators; they may even be transacted upon.

Put options have the use of being a protection mechanism. It provides the right to the sale. In an instance where you own shares and bought a put option, given that there was a fall in share prices at a future date, you will be provided with the right to sell shares at predetermined prices within the options contract.

This knowledge and the consideration of the 07/08 global Financial Crisis leads to a question if such Put options are an advisable means of protecting shares. It does so definitely, with the knowledge you’ve gained about this mechanism, the market conditions will no longer define the method you save your earnings as you will have a safeguard ready at all times.

The most difficult concept in understanding this is that steering the market is another use of Put options. Share prices may have a value falling, given that your own shares at that given time would mean you lose the positional value you hold.

A right without an obligation for the sale of shares at a set price by a given date is what a Put option generally pertains. Thus, if you are provided with the right to sell at a given value, then, in that case, there will be gaining in the Intrinsic Value of your Put option.

This is provided that the underlying share price falls; the Put option contract premium would rise. This system would be elaborated within Option pricing as a lesson. However, for the purpose of introduction to the concept, as with the fall of share prices, the Put option gains in the Intrinsic Value. Thus if a put option was purchased and the underlying share price had fallen, the Option would be sold at a higher price, gaining profit through stock falls.

Within markets that cause disarray to others, you will benefit, thus what you learn is a valuable trading tool within the market. Last but not least, Put options create income.

The premium paid by the Taker is received by the writer of the Put option. This allows for defining such Put option as;  

The obligation to Buy shares on or before an given date, at a predetermined price. Therefore the writer would be required to purchase shares, given that they are exercised although the Taker (buyer) of a Put option is given the right for selling shares only.

Within the trade of Put option being exercised, a lower share price than of the strike price is required. The reason for this is that; if share prices were higher than the strike price at hand, then the open market sale of shares can be made at a higher price. Yet, if the strike prices were higher than that of share price, takers may use the contract to sell their shares at the strike price, which is above the current value of the market.

Looking at an example,

If NAB trades at $25.35, the $25 Put strike would be lower than the share price currently used, therefore the expiration of the Option would be at a worthless value. The Taker may sell shares at a market price of $25.35 than practicing the put option to sell shares at $25.

FGL trades at $5.89. The $6 Put strike is thereby above the share price. Therefore it will have an intrinsic value amongst the strike and actual stock price. The put option would be exercised as Taker sells shares at the strike of $6 than at the market price of $5.89.

Lastly, ANZ trades at $23.63. The $25 Put strike would be a rate higher than the current share price. Therefore, the put option would be exercised.

Similar to Call options, the ATM or NTM strike input option is that closest to the current share price valuation. Yet, the ITM and OTM strike prices are different than of Call options.

The ITM strike levels are generally higher than current share prices within Put options. The difference between the share price and strike is what denotes to be the ITM strike. This is known as The Money. It is different from ITM Calls since this needs the strike levels to be below the current share price value.

The OTM strike within Put options is the strike prices lower than that of the current share price, and there is no intrinsic value for the OTM put options provided. With the share price increase, the ITM put strike levels convert into ATM and thereafter OTM. With a fall in share price, OTM strike levels convert to ATM and thereafter into ITM.

These terms and phrases would become clearer as this course is taught. What needs to keep in mind is that OTM, ATM, and ITM strikes have an impact on the strategies risk factor based on the trade.

The next requirement is to assure that an introduction to the strategies to be discussed within the course as an overview. This is mandatory for you to get an idea about what you will be learning in detail.

Directional trading will be one of the first such learning, and this can be piloted with both Call and Put options. A strategy to cause an upwards thrust within the underlying is the buying of Call options. It is a risk if a fall in share price occurs and or if there is a sideway trend in prices with the passing of time.

The Covered Calls and Buy-Write strategies are means of income generation strategies, amongst other such systems. The Covered Calls allows for owning shares and then write call options against the said shares, allowing for premium income to be earned for writing them. The strategy of Buy Write is similar, but there is an actual purchasing of the underlying shares as the call options are written.

The spread strategies allow the entering into positions of multiple options at a singular occasion at a given time. These combine both trading and income strategy and is versatile for all market environments. They include the Straddles, Debit Spreads, Credit Spreads, Calendar Spreads, Butterfly’s, and also Ratio Spreads.

The final strategies in the discussion are Naked Selling mechanisms, along with the realistic risks accompanied by the high-risk strategies in use.

The differences between both Call and Put options have been in discussion within this course. Examples have been brought forth to discuss how and when each could be exercised while denoting why they would be used. The strategies to be discussed have been introduced until now, and further, we’ve assured to define the ATM, OTM and ITM strike levels in Call and Put options herewith.