Don't know a 'put' from a 'call'? Read this

We set the record straight on some options-trading terminology.

Adam Zoll 2 September, 2014 | 6:00PM

Question: I often hear people who invest in options refer to puts and calls. Can you explain what they are and why an investor would buy or sell one or the other?

Answer: For more sophisticated investors, options can be a good way to accomplish goals that investing in a security directly cannot. Options may be used to provide exposure to an area of the market at a lower cost than buying a security outright, to hedge risk or to provide income, among other uses.

Explaining how options are used to accomplish these and other goals would go well beyond the scope of this column, as options-based strategies can be rather complex. Your local library or bookstore probably has entire volumes on the subject. But at the very least we can help clarify what some basic options-investing terminology means, including puts and calls.

Before going any further let's clarify just what an option is. In a nutshell, the owner of an option has the right, but not the obligation, to buy or sell an asset at a set price and for a set time period. Options are traded in the form of contracts and are applied to everything from stocks, bonds and ETFs to indexes, currencies and commodities. Options are a form of derivative in that their value is derived from the value of an underlying asset.

Selling the right to buy, buying the right to sell

Now on to puts and calls. A put option gives its owner the right to sell the underlying asset at a set price while a call option gives its owner the right to buy the underlying asset at a set price. (One way to remember this distinction is to visualize the seller putting an item to be sold on a table and a buyer calling for, or requesting, the item.) Complicating matters is the fact that puts can be bought and sold just as calls can be bought and sold. To help clarify what buying and selling puts and calls means, here's a breakdown:

Buying a put: Purchasing the right to sell an asset at a set price
Selling a put: Agreeing to buy the asset at the set price if the option is exercised
Buying a call: Purchasing the right to buy an asset at a set price
Selling a call: Agreeing to sell the asset at the set price if the option is exercised

Keep in mind that the owner (buyer) of the option does not have to exercise it. However, if she does, the seller of the option is obligated to buy or sell the asset at the agreed-upon price. Also, remember that options expire after a set period of time, with the time frame and price varying accordingly.

One way to use options: the covered call

As an example of how options might be used, consider an investor who thinks shares of a fictitious company we'll call Acme Rockets will rise by the end of the year but who doesn't want to risk buying the stock outright or who prefers to spread his money among other investments while still gaining exposure to the stock. The investor, who we'll call Wile E. Coyote, expects the stock, currently trading at $25 per share, to reach $30 per share by year's end. So, he pays $2 per share for a call option with a strike price--the price at which shares may be purchased--of $25 a share (equity options contracts typically represent 100 shares of the underlying stock). If Acme Rockets' share price moves higher before the call option expires, Coyote can exercise it and buy the shares for $25 apiece. He then may turn around and sell the shares at a profit or hold on to them if he wishes. For example, let's say the share price rises to $30 just as Coyote anticipated. By exercising the option, he ends up paying $2,500 (the $25 strike price multiplied by 100) for $3,000 worth of shares. Subtract from this $500 gain the $200 it cost him to buy the option and Coyote walks away with a $300 profit. However, if Acme Rockets shares fall below the strike price and he never has an opportunity to exercise the option (after all, why pay $25 for a stock that trades for less?) it becomes worthless and Coyote is out the $200 he paid for it.

The seller of the call option makes an immediate profit from its sale but runs the risk of later having to sell shares at the strike price if the market price is higher. So, if Acme Rockets' share price shoots up to $35 and Coyote exercises his call option, the seller must deliver the required number of shares to him at $25 apiece. The seller may already own Acme Rockets shares (a strategy known as a covered call) and will have to part with them but still gets to keep the $200 he made from selling the call option. However, if the seller doesn't already own Acme Rockets shares (making this an uncovered call), he will have to buy them at the market price in order to deliver on the option. In this case, the seller of the option would have to pay $3,500 to buy 100 shares of Acme Rockets stock, and then turn around and sell them to Coyote for $2,500. Minus the $200 profit from the sale of the option, the seller is out $800 on the deal.

As you can see, the cost of the option itself must be factored into the equation when buying or selling options, regardless of whether they are calls or puts. If the option costs more than the buyer or seller expects to make on the deal, there's no point in forging ahead. Options are traded on many of the major exchanges and may be traded multiple times before they are exercised.

A useful tool for those who know how to use it

By providing exposure to some investment types at a relatively low cost, options can be quite useful in executing various trading strategies. Some mutual fund managers use them extensively while others tend to stick more to buying and selling securities directly (for more on how fund managers use options and other derivatives, click here). Many trading platforms allow individual investors to trade options. But before proceeding, make sure you have a clear understanding of how they work and a well-thought-out strategy. Options can present opportunity for those with the skill to use them well. But they can also mean a costly lesson for those who lack it.

About Author

Adam Zoll

Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com