Call vs. Put Options: Payoffs and Use Cases
Call vs. Put Options: Payoffs and Use Cases
Options contracts provide the right, but not the obligation, to buy or sell an underlying asset at a specified price before a certain date. Understanding the difference between call options and put options is fundamental to using these instruments effectively.
Definition and Key Concepts
A call option gives the holder the right to buy the underlying asset at the strike price before or at expiration. Call buyers pay a premium upfront and profit when the underlying price rises above the strike price plus the premium paid.
A put option gives the holder the right to sell the underlying asset at the strike price before or at expiration. Put buyers pay a premium upfront and profit when the underlying price falls below the strike price minus the premium paid.
Core Terminology
| Term | Definition |
|---|---|
| Strike Price | The price at which the option holder can buy (call) or sell (put) the underlying |
| Premium | The price paid to purchase the option contract |
| Expiration Date | The last date on which the option can be exercised |
| Underlying | The stock, ETF, or index that the option contract references |
| In-the-Money (ITM) | Call: spot > strike; Put: spot < strike |
| Out-of-the-Money (OTM) | Call: spot < strike; Put: spot > strike |
| At-the-Money (ATM) | Spot price approximately equals strike price |
How It Works in Practice
When you buy an option, your maximum loss is limited to the premium paid. When you sell an option, your potential loss can be substantial or even unlimited (for uncovered calls).
Call Option Payoff at Expiration:
- If Stock Price > Strike Price: Payoff = Stock Price - Strike Price - Premium
- If Stock Price ≤ Strike Price: Payoff = -Premium (option expires worthless)
Put Option Payoff at Expiration:
- If Stock Price < Strike Price: Payoff = Strike Price - Stock Price - Premium
- If Stock Price ≥ Strike Price: Payoff = -Premium (option expires worthless)
Typical Use Cases
Call Options:
- Speculating on upside price movement with limited downside risk
- Gaining leveraged exposure to an asset without purchasing shares outright
- Hedging a short stock position
Put Options:
- Speculating on downside price movement
- Protecting an existing long stock position (protective put)
- Generating income when sold against cash reserves (cash-secured put)
Worked Example
Consider XYZ stock trading at $100 per share on January 15.
Call Option Example:
- Strike Price: $105
- Premium: $3.00 per share ($300 per contract, since each contract = 100 shares)
- Days to Expiration: 45
- Delta: 0.35 (35% probability of finishing in-the-money)
| Stock Price at Expiration | Call Payoff per Share | Net Profit/Loss per Contract |
|---|---|---|
| $95 | $0 | -$300 |
| $100 | $0 | -$300 |
| $105 | $0 | -$300 |
| $108 | $3 | $0 (breakeven) |
| $115 | $10 | +$700 |
The breakeven point is $108 ($105 strike + $3 premium).
Put Option Example:
- Strike Price: $95
- Premium: $2.50 per share ($250 per contract)
- Days to Expiration: 45
- Delta: -0.30 (30% probability of finishing in-the-money)
| Stock Price at Expiration | Put Payoff per Share | Net Profit/Loss per Contract |
|---|---|---|
| $105 | $0 | -$250 |
| $100 | $0 | -$250 |
| $95 | $0 | -$250 |
| $92.50 | $2.50 | $0 (breakeven) |
| $85 | $10 | +$750 |
The breakeven point is $92.50 ($95 strike - $2.50 premium).
Risks, Limitations, and Tradeoffs
Time Decay
Options lose value as expiration approaches, a phenomenon called time decay (theta). All else equal, an option with 45 days to expiration will lose value each day, accelerating as expiration nears. This works against option buyers and in favor of option sellers.
Leverage Cuts Both Ways
While options provide leveraged exposure—allowing control of 100 shares for a fraction of the stock price—losses can accumulate quickly when trades move against you. A 100% loss of premium is common when options expire worthless.
Liquidity Considerations
Not all strikes and expirations have equal liquidity. Wide bid-ask spreads increase trading costs and can make it difficult to exit positions at fair prices. Focus on options with high open interest and tight spreads.
Assignment Risk
Option sellers face assignment risk, meaning they may be required to buy or sell the underlying at the strike price. American-style options can be assigned at any time before expiration, while European-style options can only be exercised at expiration.
Common Pitfalls
- Ignoring time decay: Buying options too far out-of-the-money with little time left often results in total loss of premium.
- Oversizing positions: Using too much capital on single options trades can devastate a portfolio.
- Misunderstanding breakeven: Many new traders forget to account for the premium paid when calculating profitability.
- Neglecting liquidity: Trading illiquid options leads to poor fills and difficulty exiting positions.
Checklist Before Trading Options
- Confirm you understand the difference between buying and selling options
- Calculate your maximum potential loss before entering the trade
- Check the bid-ask spread and open interest for adequate liquidity
- Verify the expiration date and days to expiration
- Determine your breakeven price including premium paid
- Review your broker's options agreement and ensure appropriate approval level
- Read the OCC Options Disclosure Document
Next Steps
Once you understand call and put payoffs, explore how strike selection, expiration timing, and underlying choice affect option pricing. The article on Option Contract Specifications: Strike, Expiry, Style covers these details in depth.
Options involve significant risk and are not appropriate for all investors. Before trading, read the Characteristics and Risks of Standardized Options disclosure document available from your broker or the Options Clearing Corporation.