How does a call option work?
A call option is a contract tied to a stock. You pay a fee, called a premium, for the contract. That gives you the right to buy the stock at a set price, known as the strike price, at any point until the contract’s expiration date.
You’re not obligated to execute the option. If the price of the stock increases enough, then you can execute it or sell the contract itself for a profit. If it doesn’t, then you can let the contract expire and only lose the premium you paid.
The breakeven point on a call option is the sum of the strike price and the premium. When you have a call option, you can calculate your profit or loss at any point by subtracting the current price from the breakeven point. There’s also a calculator you can use at the bottom of this page.
As an example, let’s say that you’re bullish on Apple (NASDAQ:AAPL) and it’s trading at $150 per share. You buy a call option with a strike price of $170 and an expiration date six months from now. The call option costs you a premium of $15 per share. Since options contracts cover 100 shares, the total cost would be $1,500.
The breakeven point would be $185 since that’s the sum of the $170 strike price and the $15 premium. If Apple reaches a price of $195, your profit would be $10 per share, which is $1,000 total. If it only goes to $175, you’d have a loss of $10 per share. Your maximum potential loss would be the $1,500 you paid for the premium.
How does a put option work?
A put option is a contract tied to a stock. You pay a premium for the contract, giving you the right to sell the stock at the strike price. You’re able to execute the contract at any point until its expiration date.
If the price of the stock decreases enough, then you can sell your put option for a profit. You’re not obligated to execute the contract, so if the price of the asset doesn’t drop enough, you can let the contract expire.
The breakeven point on a put option is the difference between the strike price and the premium. When you have a put option, you can calculate your profit or loss at any point by subtracting the breakeven point from the current price, or by using the calculator at the bottom of this page.
To give you an example, imagine Netflix (NASDAQ:NFLX) trades at $500 per share. You think it’s overvalued, so you buy a put option with a strike price of $450 and an expiration date three months away. The premium costs $10 per share, which is a total price of $1,000 for the contract.
The breakeven point would be $440, the difference between the $450 strike price and the $10 premium. If Netflix plummets to $400, then you’re up $40 per share ($4,000 total) on your put option. If it doesn’t drop below $450 at all, then you’d only be able to let the option expire and eat the cost of the premium.