What Are Calls and Puts in the Stock Market?
- A stock option is a type of "derivative," which means that its value is based on another entity, called an "underlying." When the underlying changes in value, the stock option also changes, but its pricing is based on a complex formula. Each stock option is technically a contract between two parties, but in practice these parties are anonymous, and the contracts trade on the public exchanges much like stock. For most stock options, the underlying is an actual stock, but stock options are also traded for stock market indices as well as exchange-traded funds. Calls and puts are available on all these underlying instruments.
- Unlike stock, which you may hold indefinitely, a stock option will expire and no longer exist. The expiration date is set as part of the contract's terms and always occurs on the third Friday of the expiration month. You can buy stock options that expire within the month as well as those that expire up to three years in the future. Before a stock option expires, you have three choices. You can sell the stock option back to the market, just as you would stock, and take any profits or losses incurred on the transaction. Or you may execute the terms of the option, called "exercising." If a stock option lost most of its value while you held it, your third choice is to let the option expire.
- A "call" option is a contract for the purchase of the underlying at a predetermined price at any time before the contract expires. In the U.S., all stock options involve 100 shares of the underlying for each contract. A typical call option may be listed as AAPL 250 March 2011. This means that for each contract you hold, you have the right to purchase 100 shares of Apple stock at a price of $250 per share at any time before the contract expires in March of 2011. This call would be very valuable if, at any time while you hold the contract, Apple traded at more than $250 per share, as the contract would let you buy shares of the stock at a discount of its actual market value.
- A put option is the opposite of a call. It lets you sell stock based on the contract's terms, rather than buy stock. Puts are common hedging vehicles. If you own a lot of stock, you may wish to protect against a major decline in share prices by purchasing some puts. These act as a form of insurance. As prices drop, your stock declines, but your puts rise because they become more valuable. You could have very valuable puts if they allow you to sell stock at a price higher than the stock's actual market value.
- Calls and puts are characterized by high leverage. That is, their prices change quickly due to small fluctuations in the underlying. Traders with a high risk tolerance may choose to trade options instead of trading the actual stock. If they are correct in their predictions, the returns are substantially greater. But the risks always remain high.