You hear these two words in nearly every investing class – “call option” and “put option”. So what do these two words mean exactly?
Firstly, they are both options. An option is basically an agreement between two parties. That’s it.
- Call Option – An agreement that gives you the option to buy an asset at a specified price.
- Put Option – An agreement that gives you the option to sell an asset at a specified price.
From here forward, I’ll be using the term “strike price” instead of “specified price”. You can think of the strike price as the price you purchased a newly created option at.
- Call Option – You want the stock price to increase. You make money if strike price > current market price.
- Put Option – You want the stock price to decrease. You make money if strike price < current market price.
Let’s take an example:
- Company Name: Apple
- Strike Price: $100 (i.e. Stock price when option was newly issued)
Call option
If Apple’s stock price was to increase to $120, you would be able to exercise your call option to buy Apple shares at $100 and sell them instantly on the market at the market price of $120. This means that you’d earn a profit of $20 per share.
Put option
On the other hand, if Apple’s stock price was to decrease to $80, you would be able to exercise your put option and buy Apple’s shares at the $80 market price, but sell them at the $100 strike price. This means that you’d earn a profit of $20 per share.
