Understanding the difference between selling a call option and buying a put option
Options trading is a versatile financial instrument used to hedge risk or speculate on price movements in various underlying assets such as stocks, indices, or commodities. Among the different strategies traders use, selling a call option and buying a put option are two distinct approaches that both benefit from bearish market movements but differ in terms of risk exposure, market outlook, and potential profit or loss. Understanding the key differences between these two strategies is crucial for both novice and advanced traders.
Let’s explore each concept in detail, followed by a comparison of their differences.
1. What is Selling a Call Option?
A call option gives the buyer the right (but not the obligation) to buy an underlying asset at a predetermined price (the strike price) before or on the option's expiration date. When a trader sells a call option, they are essentially taking the opposite position of the buyer. This means they are taking on the obligation to sell the underlying asset to the call option buyer at the strike price if the option is exercised.
Market view: When you sell a call option, you are typically bearish or neutral on the underlying asset. You expect the asset’s price to either stay below the strike price or remain flat so that the option will expire worthless, and you can keep the premium received from selling the option.
Maximum profit: The maximum profit in selling a call option is limited to the premium received when selling the option. If the option expires worthless (i.e., the price of the underlying asset does not exceed the strike price), you keep the entire premium.
Maximum loss: The potential loss in selling a call option can be unlimited if the underlying asset’s price rises significantly above the strike price. Since the seller is obligated to sell the asset at the strike price, they might face substantial losses if the market price skyrockets.
Obligation vs. right: When you sell a call, you are not buying the right to do anything; instead, you are taking on the obligation to sell the asset if the buyer exercises their option.
Covered vs. naked call: A covered call is when the seller already owns the underlying asset and is willing to sell it if the price rises. A naked call is riskier, as the seller does not own the underlying asset, which can result in significant losses if the asset’s price increases dramatically.
Example of selling a call option
Let’s say stock XYZ is trading at Rs.50, and you sell a call option with a strike price of Rs.55, expiring in one month, for a premium of Rs.2. If, at expiration, the stock remains below Rs.55, the option expires worthless, and you keep the Rs.2 premium.
However, if the stock price rises to Rs.60, the option buyer will likely exercise their option to buy at Rs.55. This means you’ll have to sell the stock at Rs.55, even though it’s trading at Rs.60 in the market. Your loss would be the difference between Rs.60 and Rs.55, minus the premium you received (Rs.2), resulting in a net loss of Rs.3 per share.
2. What is Buying a Put Option?
A put option gives the buyer the right (but not the obligation) to sell an underlying asset at a predetermined strike price before or on the option's expiration date. When you buy a put option, you are betting that the price of the underlying asset will fall below the strike price before expiration.
Market view: Buying a put option is a bearish strategy. You profit if the price of the underlying asset declines significantly. If the asset’s price drops below the strike price, you can either sell the asset at the higher strike price (if you own it) or sell the put option for a profit.
Maximum profit: The maximum profit when buying a put is theoretically substantial, depending on how far the asset’s price drops. The lower the asset’s price falls, the more valuable the put option becomes. However, the maximum potential profit is capped if the asset’s price goes to zero.
Maximum loss: The maximum loss is limited to the premium paid to buy the put option. Even if the asset’s price stays above the strike price and the option expires worthless, the only loss you’ll face is the premium paid for the option.
No obligation: When buying a put, you are not obligated to sell the asset at the strike price. You have the right to sell if it becomes advantageous (i.e., if the market price falls below the strike price), but if the asset’s price stays high, you can simply let the option expire and lose only the premium.
Example of buying a put option
Assume stock XYZ is trading at Rs.50, and you buy a put option with a strike price of Rs.45, expiring in one month, for a premium of Rs.2. If the stock price falls to Rs.40, you can sell the stock at Rs.45, netting a profit of Rs.5, minus the Rs.2 premium, for a total profit of Rs.3 per share.
However, if the stock price remains above Rs.45, the option expires worthless, and you lose the Rs.2 premium paid.
Key differences between selling a call option and buying a put option
Now that we have a clear understanding of what selling a call option and buying a put option entail, let’s examine the key differences between these two strategies:
1. Market outlook
Selling a call: When you sell a call option, you are betting that the price of the underlying asset will either stay flat or decline slightly. This is a neutral to bearish strategy. The goal is for the option to expire worthless, so you can keep the premium.
Buying a put: When you buy a put option, you are explicitly bearish. You expect the price of the underlying asset to drop significantly, and you profit from that decline.
2. Risk vs. reward
Selling a call: Selling a call option has limited profit potential but unlimited risk. The maximum you can earn is the premium received, but if the asset’s price rises sharply, your losses can be substantial, especially in a naked call scenario.
Buying a put: Buying a put option has limited risk (equal to the premium paid) and substantial profit potential. The more the asset’s price falls, the more profitable the put option becomes.
3. Obligation vs. right
Selling a call: The seller of a call option has an obligation to sell the underlying asset if the option is exercised. This makes selling a call riskier than buying a put, especially if the market moves sharply against you.
Buying a put: The buyer of a put option has the right to sell the underlying asset at the strike price but is under no obligation to do so. This gives the put buyer more flexibility, as they can choose not to exercise the option if the market doesn’t move in their favor.
4. Use in hedging
Selling a call: This strategy is often used by investors who already own the underlying asset (covered calls) and want to generate additional income through premiums. However, it does not offer downside protection since losses can still occur if the asset’s price declines.
Buying a put: Buying a put option is a common hedging strategy used to protect against potential declines in the value of a portfolio or individual stock. It acts as insurance against falling prices.
Conclusion
Both selling a call option and buying a put option are used in options trading to take advantage of different market scenarios, particularly when anticipating bearish movements. However, they differ significantly in terms of risk, potential profit, and market outlook. Selling a call exposes you to unlimited risk for a limited reward, making it a strategy best suited for experienced traders with a neutral to slightly bearish outlook. Buying a put, on the other hand, provides a straightforward way to profit from falling markets with limited risk, making it more suitable for those with a strongly bearish market expectation or those looking to hedge against potential losses. Understanding these differences is essential for making informed trading decisions.
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