Calls vs Puts: Understanding the Two Types of Options

Investing and trading can seem complicated. You might hear terms thrown around that sound like another language. One area that often confuses newcomers is options trading. But what exactly are options, and what are the main types you’ll encounter? 

First Off, What Is an Option?

Before diving into calls and puts, let’s understand what an option is.

Think of an option as a contract. This contract gives the buyer the right, but not the obligation (meaning they don’t have to), to either buy or sell an underlying asset at a specific price on or before a certain date.

Let’s break down the key parts:

• Underlying Asset: This is the actual thing the option contract is based on. It could be shares in a company listed on the Johannesburg Stock Exchange (JSE) like Naspers or Standard Bank, a currency pair like USD/ZAR, or even commodities like gold or oil.
• Strike Price: This is the fixed price at which the option holder can buy or sell the underlying asset. It’s set when the contract is created. 
• Expiry Date: Options don’t last forever. This is the date the contract expires. After this date, the option is worthless.
• Premium: This is the price you pay to buy the option contract itself. Think of it as the fee for securing the right to buy or sell later.

Okay, now that we have the basics, let’s look at the two main types: calls and puts.

Call Options: Betting on a Price Increase

A call option gives the holder the right to buy the underlying asset at the strike price before the expiry date.

Why would someone buy a call option? Usually, it’s because they believe the price of the underlying asset is going to rise significantly before the option expires.

• Think: Call = Option to Climb (price going up).
• Simple Example: Let’s say Shoprite shares are currently trading at R200 per share on the JSE. You believe the price will go up soon. You could buy a call option with a strike price of R210 that expires in three months. You’ll pay a premium for this option, let’s say R5 per share.
  • If Shoprite’s share price jumps to R230 before expiry, your option is valuable. You have the right to buy shares at R210 (your strike price), even though they are trading at R230. You could exercise the option, buy the shares at R210, and potentially sell them immediately for R230, making a profit (minus the R5 premium you paid).
  • If Shoprite’s share price stays below R210, or only goes up slightly, your option might expire worthless. You wouldn’t exercise your right to buy at R210 if you could buy cheaper on the open market. In this case, you only lose the premium you paid (R5 per share).

Buyers of call options are generally “bullish” – they expect the price to go up. The person who sells the call option generally believes the price will stay flat or go down. They collect the premium hoping the option won’t be exercised.

Put Options: Betting on a Price Decrease

A put option gives the holder the right to sell the underlying asset at the strike price before the expiry date.

Why buy a put option? Usually, because you believe the price of the underlying asset is going to fall before the option expires.

• Think: Put = Option to put it (sell it) onto someone else if the price drops.
• Simple Example: Let’s say MTN shares are trading at R100. You think the price might fall due to market conditions. You could buy a put option with a strike price of R95 that expires in two months. Let’s say the premium is R3 per share.
  • If MTN’s share price drops to R80 before expiry, your put option is valuable. You have the right to sell shares at R95 (your strike price), even though they are only worth R80 on the market. You could potentially buy shares at R80 and immediately exercise your option to sell them at R95, making a profit (minus the R3 premium).
  • If MTN’s share price stays above R95, your option will likely expire worthless. You wouldn’t exercise your right to sell at R95 if the market price is higher. You only lose the premium you paid (R3 per share).

Buyers of put options are generally “bearish” – they expect the price to go down. The seller of the put option collects the premium, hoping the price stays flat or rises, so the option isn’t exercised against them.

Finding Your Way in Options Trading

Options trading allows for different strategies beyond just buying shares. You can use them to speculate on price movements (up or down) or even to protect existing investments (hedging). However, it’s crucial to understand that options are complex and carry significant risk. The value of options can change quickly, and buyers can lose their entire premium paid. Sellers of options can potentially face even larger losses.

To trade options, you typically need an account with a broker that offers them. Some brokers offer different types of options. For instance, platforms like easyMarkets provide access to trading vanilla options. Vanilla options are the standard call and put options we’ve discussed here – they have straightforward terms like a set strike price and expiry date, making them the fundamental building blocks for understanding options trading before looking into more complex variations.

Before trading options, always ensure you fully understand how they work and the risks involved. Do your homework, consider starting small if you do decide to proceed, and never invest more than you can afford to lose.