What Are Call and Put Options?

When it comes to investing, you have options — literally. Options are contracts that give you the right — but never the obligation — to buy or sell shares of a stock for a certain price by a certain date. When your contract gives you the right to buy shares, it’s a call option. When your contract gives you the right to sell shares, it’s called a put option. 

So “call” means “buy” and “put” means “sell.” Simple enough, right? Well, beyond that basic definition, call and put options come with their own risks and rewards. And investors interested in options trading should know about them. Below, we’ll break down both types of options contracts and show you how they work. 

What are call and put options? 

Again, options are contracts that give you the right (but never the obligation) to buy or sell shares of a stock at a specified price before a certain date. The specified price is called the “strike price.” Each options contract typically gives you the right to buy or sell 100 shares.

Your options contract has a price, called the “premium,” and it’s displayed as the price per share. An options contract with a premium of $10, then, would cost you $1,000, if it gave you the right to buy 100 shares. 

Call options give you the right to buy an underlying security (such as a stock) for the strike price before an expiration date. If you don’t execute your right to buy before this date, your call option contract will become worthless. Typically, investors will buy call options when they believe the price of the underlying security will go up. In this way, they can buy 100 shares at the lower strike price, then resell them at the prevailing market price. 

Put options, on the other hand, give you the right to sell an underlying security for the strike price before an expiration date. Again, if you decide not to sell your shares before the expiration date, your put option contract is worth nothing. In contrast to call options, investors usually buy put options when they believe the price of a stock will go down. In this way, they can sell their shares at the higher strike price, then rebuy at the lower market price. 

How do call options work? 

Having a call option means you can buy shares of a stock at a fixed price (the strike price) before the contract expires. Typically, you buy a call option when you believe a stock is undervalued: by agreeing to a lower strike price now, you can buy at that low price if the stock’s value goes up. No matter how high the stock’s price goes in the market, the call option seller must sell you shares at the strike price, if you execute your right to buy. 

Call options have a break-even point, which helps you calculate your profit or loss. To find the break-even point on a call option, add the strike price and the premium. At any point during your contract, you can calculate your profit (or loss) by subtracting the stock’s current price from this break-even point. 

For example, imagine ABC stock trades at $200 per share. You think it’s undervalued, so you buy a call option with a strike price of $220 and an expiration date of three months away. For the contract, you’ll pay a premium of $10 per share, which comes out to $1,000. 

The break-even point would be $230 (the strike price plus the premium). If ABC stock hits $240, then you would make $10 per share, or $1,000 total. If it stayed at $230 per share, however, then you would earn nothing. In fact, you would lose money. You’d still pay the $1,000 premium, but without any profit from the stock itself. 

How do put options work? 

When you believe a stock’s price will go down, you can buy a put option. Like call options, a put option has a premium, an expiration date, and a strike price. If the price of a stock falls below the strike price, you can execute your right to sell your put option for a profit. 

Similar to call options, put options have a break-even point, though the method of calculating it is slightly different. Instead of adding the strike price and the premium, you find the difference between them. Then, to calculate your profit or loss, you subtract the break-even point from the stock’s current price. 

Again, let’s say you’re watching ABC stock, which trades at $200 per share. This time you think it’s overvalued, so you buy a put option with a strike price of $190. Again the premium costs $10 per share for a total of $1,000 for the contract. 

In this case, the break-even point is $180 (the strike price minus the premium). Now, let’s say ABC stock plummets to $170 per share. In this case, you’ll make $10 per share, or $1,000 total. 

What are the risks of call options and put options? 

Perhaps the greatest risk of buying options, whether call or put, is that the stock moves in the opposite direction you were expecting. For call options, that means the stock’s price goes down instead of up. In this case, you wouldn’t execute your right to buy. You would pay the cost of the premium and let your contract expire. For put options, it’s the opposite. If the stock’s price goes up, then your options contract becomes worthless, and you’ll pay the cost of the premium. 

Another risk is knowing when to execute your contract. Even if your hypothesis does play out — if the underlying stock moves in the direction you expect — you have to know when to execute your right to buy or sell. You may wait too long and miss your opportunity to turn in your contract. Or, conversely, you may turn your contract in too soon and miss out on bigger potential gains. 

Call vs. put options: which is right for you? 

To sum up, call options allow you to buy shares of stock at a strike price before an expiration date, whereas put options allow you to sell shares at a strike price before a specific date. 

Whether you’re interested in call options or put options, keep in mind that options trading is a fairly advanced strategy used mostly by experienced investors. In fact, when compared to stock investing, options trading presents more risks. That’s because with options trading, you have to predict three things correctly: 

  • How the underlying stock’s price will move (up or down) 
  • How quickly the stock will move (the time period)
  • The right time to execute your contract 

For this reason, if you’re new to investing, or you’re fairly risk averse, then you might want to stick to a buy-and-hold strategy. Options trading has a lot of room for error. The gains can be attractive, but you could end up losing money that could have been more wisely invested.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

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