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Buying a put v/s selling a call: How to decide

Many F&O traders normally are confused between buying a put option versus selling a call option. A call vs. put may be a source of much doubt in the minds of traders and novice investors. Broadly both are bearish strategies, and the difference between a call and put option is that while the former is a right to buy the latter is a right to sell. Obviously when you buy an option your risk is limited to the premium you pay. That is because your loss is limited to the premium paid while your profits can be unlimited. On the other hand, when selling an option, your income is limited to the option premium received, but the losses can be technically unlimited. Let us understand the difference between a call and a put option with an example. Let us also understand how to trade in call and put options, both on the buy side and the sell side.

What is a call option and put option?

Before you understand the difference between a call and a put with an example, you should note that call and put options are bought and sold with a contract. If you purchase an options contract, the contract gives you the right (but not the obligation) to purchase or sell any underlying asset. Moreover, the buying and selling price is fixed in accordance with a date limit or before that, based on terms of the contract. What a call option does, therefore, is gives the holder the right to purchase a stock. The put option gives the stockholder the right to sell any stock.

Call and put option with a live example

If you are still muddled up about a call and put option, you will be able to better grasp the concepts with an example that follows:

Let us assume that the current market price of Tata Steel in the spot market is Rs.695/-

ContractCall PremiumPut PremiumITM or OTMNovember 680 Call24.00-ITMNovember 680 Put-7.00OTMNovember 720 Call7.50-OTMNovember 720 Put-28.20ITM Date Source: NSE

An In-the-Money (ITM) option is one that has intrinsic value and time value. Take the case of the 680 Call Option on Tata Steel. The Call is currently quoting at Rs.24, of which Rs.15 is explained by the intrinsic value of call option (695-680). The balance Rs.9 is the time value. In the case of the 680 put, the intrinsic value is zero and so the entire Rs.7 is explained by time value of money.

Let us come to the 720 strike. The 720 Put is currently quoting at Rs.28.20. Of this Rs.25 is explained by intrinsic value (720-695) and the balance Rs.3.20 is explained by time value of money. In case of the 720 call the entire Rs.7.50 is the time value of money.

What determines the economics of buying a put versus selling call?

As we have already seen, you buy a put option when you expect sharp downsides in the stock. How do you determine when a stock is going to slip and go with a downward trend? You may see a gradual drop in price and expect this to continue, or certain market or economic conditions may lead you to expect prices of a stock to drop. Hence, you decide to go with the best option when you think a stock will plunge. As a result, you bet by limiting your risk to the option premium and play for the downside in the stock. You sell a call option when you expect that the upsides for the stock are limited.

You are indifferent to whether the stock is stable or goes down as long as the stock does not go above the strike price. Before getting into how to trade in a call and put option, let us first understand the difference between call and put positions with the example above.

You can understand call vs. put options by assuming the actions of two kinds of investors. These, for the sake of representation, are called Alpha and Beta.

Let us now consider the behaviour of the 2 investors viz. Alpha and Beta. Alpha is an aggressive investor, a taker of risks in the stock market, who believes that with the metals cycle already overpriced, Tata Steel price should correct. He expects the price to correct to Rs.640 in the next 1 week. He can sell the Tata Steel 680 call and get a maximum profit of Rs.24, which is a good profit on his margin. However, Alpha is taking on a very huge risk here. Since Alpha has sold the 680 Call at Rs.24, he is only covered up to Rs.704. Any price above that will result in unlimited losses for Alpha. The better option will be buying the 680 November Put option. If the price touches Rs.640, then he makes a profit of Rs.33/- (40-7). In a worst case scenario if the Tata Steel stock goes up to any level, his loss is limited only to Rs.7/- share.

Now, let us consider the case of Beta who is a less risky and more conservative player. Beta is of the view that the stock may be hovering in a range. While downsides are open, its upside is limited to Rs.720. The best option for Beta is to sell the 720 call. Buying the 720 put may be too expensive and buying the 680 put may be too out of the money. Selling the 720 call will give him a premium of Rs.7.50 and serve his view.

Buying a put option versus selling a call option: How to decide?

You may have understood the primary difference between a call option and when to buy a put option, but you may be wondering how to decide between the two. Your decision whether you should buy a put option or sell a call option will be broadly guided by the following 4 considerations:

Are you having an affirmative view on the stock or index going down? In that case it makes more sense for you to buy the put option. Your downside risk will be limited to the option premium paid and your profits in case the stock falls will be unlimited.

Are you having a cautiously non-affirmative view on the stock? In this case you are only confident that the stock price is unlikely to rise beyond a point. You are indifferent to whether the stock price goes down or stays stagnant at current levels. In such cases, it makes eminent sense to sell the call at the strike where you believe the stock to top out. You can also sell a lower call for a higher premium but that is taking on unnecessary risk. While some aggressive stockholders may go with risk, however unnecessary, it is prudent to avoid this as you make a calculated decision to avoid losses.

Can you pay the margins for the trade? When you buy a put option, your total liability is limited to the option premium paid. That is your maximum loss. However, when you sell a call option, the potential loss can be unlimited. Hence your margin will be exactly like how the margins are imposed on futures. Be prepared for higher capital outlay in this case.

Lastly, are you playing for a rise in volatility or fall in volatility in the market? If you are playing for a rise in volatility, then buying a put option is the better choice. However, if you are betting on volatility coming down then selling the call option is a better choice.

How to trade put and call options is all about knowing the difference between call and put options in terms of risk and return potential. Your choice can actually be a simple one, depending on the investment strategy you take and the kind of personality you have, a risk-averse investor or a risk taker.

Why use a call and put option?

The reason that investors use call and put options is largely because of speculation. This is mainly a wager on the direction of future prices of stocks. A speculator may believe that the price of stocks may rise, based on some fundamental analysis, technical analysis, or other factors. Therefore, a speculator buys a stock or buy a call option with the stock. Speculating on a call option, rather than buying the stock outright, is appealing to certain traders for the simple reason that options give them leverage. An “out-of-the-money’ call option may cost you only a limited amount, compared to the full price of an expensive stock.

Do you know why options were invented? The main reason was for the purpose of being a hedge, reducing risk at a decent enough cost. Here, you may think of options as representing an insurance policy. In the same way that you may insure your car or your home, options may be seen as insurance for your investments, acting to combat any downturns. You may think a stock is risky to buy, yet wish to limit losses. You can limit loss, with options trading, and enjoy any upsides when they come.

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