Call and put option Summary Guide

We have previously analysed two primary types of options—the call option and put option. Additionally, we looked at four diverse variants stemming from these two choices.

1. Buying a Call Option
2. Selling a Call Option
3. Buying a Put Option
4. Selling a Put Option

A trader has numerous options for creating viable strategies, commonly known as ‘Option Strategies‘. Picture this – a great artist can take a range of colours and paint an amazing masterpiece; similarly, a skilful dealer can employ these four option variants to master trading. Imagination and intelligence are necessary for crafting these trades. Consequently, it is imperative to give due attention to the four variants while we delve into options. Therefore, in this module let’s quickly recap the facts we have comprehended thus far.

Reorganising the Payoff diagrams in this manner can help improve our understanding of several points. 

1. Upon observation, it can be noticed that the pay-off diagrams of buying a Call Option and selling a Call Option are mirror images of each other. This reflects the fact that risk-reward characteristics of an option buyer and seller are reversed. The maximum loss of a call option buyer corresponds to the maximum profit of a call option seller, while the potential for profit is infinite for the former, it is capped at the maximum loss for the latter.
2. By placing the payoffs of buying a Call Option and selling a Put Option side by side, we can clearly see that both strategies are profitable only when the market is expected to rise. Therefore, it is important to avoid buying a call option or selling a put option if you anticipate a potential market downturn, as this would lead to losses. It’s worth noting that option premiums are also influenced by volatility, which we will delve into in subsequent discussions.
3. The pay off diagrams of Put Option (sell) and Put Option (buy) are stacked one below the other on the right. The payoff diagrams for the put option buyer and seller mirror each other, highlighting that the maximum loss for the buyer corresponds to the maximum profit for the seller. On top of that, the potential profit for the put option buyer is infinite, as similarly, a maximum loss is what faces the put option seller.

Remember that when buying an option, it is referred to as a ‘Long’ position. Specifically, buying a call option and a put option is known as a Long Call and Long Put position, respectively.

Whenever you sell an option, it is referred to as a Short position. This applies to both the sale of a call and put option, which are known respectively as Short Call and Short Put.

It is possible to purchase an option under two conditions: 

1. To diversify, you purchase a new option to bolster your portfolio.
2. You purchase in order to close out an existing short position.

The position of ‘Long Option’ is used when creating a new buy order, while if you are buying to offset an existing short position, then it is referred to as a ‘square off’.

Likewise, there are two circumstances under which you can sell an option:

1. You want to establish a new short position.
2. You look to end an existing long position by selling.

Creating a fresh sell position is known as the ‘Short Option’, while closing an existing long position, it is simply called a ‘square off’.

– Option Buyer in a nutshell

As you have now understood call and put options from both the buyer’s and seller’s viewpoint, but I think it would be beneficial to reiterate some of the key points before continuing with this module.

Buying an option (call or put) can be a good decision when we are expecting the market to move considerably in a specific direction. The option purchaser needs to pick a strike price that will prove to be profitable – an issue we will learn more about later on. Here are some key items that ought to remain in our minds:

1. The profit and loss (P&L) of a long call option at expiry is calculated using the formula: P&L = Max [0, (Spot Price – Strike Price)] – Premium Paid. Similarly, the P&L of a long put option at expiry is calculated as: P&L = [Max (0, Strike Price – Spot Price)] – Premium Paid.
2. It is important to note that these formulas are applicable only when the trader intends to hold the long option until expiry. 
3. The intrinsic value calculation we discussed in previous chapters is specifically applicable on the expiry day and cannot be used during the series.
4. If the trader intends to close the position before expiry, the P&L calculation will be different. 
5. Factors such as time value decay and changes in option premiums need to be considered in such cases.
6. The buyer of an option faces limited risk, which is equal to the premium paid. However, they have the potential for unlimited profits if the market moves favourably.

– Option seller in a nutshell

The option writers, either call or put, are in for two very different types of P&L experiences. When selling an option, it is because one anticipates the market either staying flat or going below the call strike price, or above the put one.

It is important to remember that the odds are in the favour of option sellers, all things being equal. This is because for them to be successful, the market can either remain static or move as specified, whereas for an option buyer to make a profit, it must move accordingly. Therefore, two scenarios are available to option sellers as opposed to one for buyers – yet this should not alone act as a reason to sell options.

Here are some important points to remember when it comes to selling options:

1. The profit and loss (P&L) for a short call option at expiry is calculated as: P&L = Premium Received – Max [0, (Spot Price – Strike Price)]. Similarly, the P&L for a short put option at expiry is calculated as: P&L = Premium Received – Max (0, Strike Price – Spot Price).
2. It is crucial to note that these P&L formulas apply only if the trader intends to hold the position until expiry. If the position is closed before expiry, different factors such as time value decay and changes in option premiums come into play.
3. When you sell options, certain margins are blocked in your trading account as a risk management measure.
4. The seller of the option faces unlimited risk but has limited profit potential, which is equal to the premium received.
5. It is important to carefully consider these factors before engaging in option selling strategies.

In his book “Fooled by Randomness,” Nassim Nicholas Taleb discusses how option writers can enjoy steady and moderate gains from selling options. However, in the event of a significant market disaster, they may face substantial losses. This idea is often captured by the saying: “Option writers eat like a chicken but shit like an elephant.”

Over the remainder of this module, our primary focus shall be on moneyness, premiums, option costs, option Greeks and strike choices. When all of these topics have been thoroughly explained, we will revisit calls and puts from a different perspective; one that will equip you to approach options trading at a professional level.