As with most investment vehicles, risk is inevitable. Options contracts are considered risky due to their complex nature, but knowing how options work can help reduce the risk level. Call options and put options essentially come with the same degree of risk.
Depending on which "side" of the contract the investor is on, risk can range from a small prepaid amount of the premium to unlimited losses. Investors who know how each work helps determine the risk of an option position.
Key Takeaways
- A put option and a call option are two types of options contracts.
- Depending on the contract, risk can range from a small prepaid amount of the premium to unlimited losses.
- The long call option poses less risk than the naked call option, which relies on the movement of the market price.
What Is an Options Contract?
"Puts" and "Calls" are two types of options contracts. Both can be purchased to speculate on the direction of a security or hedge exposure or sold to generate revenue.
A call option is a financial contract that givesthe buyer the right to buy a stock, bond,commodity, or other asset or instrument at a specified price within a specific period.A put option is a contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of anunderlying securityat a predetermined price within a specified timeframe.
Level of Risk
In order of increasing risk, the long call option poses the least amount of risk as compared to the naked call option, which relies on the movement of the market price to determine the cost and risk to the investor.
- Long Call Option: Investor A purchases a call on a stock, giving them the right to buy it at the strike price before the expiry date. They only risk losing the premium they paid if the option is not exercised.
- Covered Call: Investor B, who wrote a covered call to Investor A, takes on the risk of being "called out" of their long position in the stock, potentially losing out on upside gains.
- Covered Put: Investor A purchases a put on a stock they currently have a long position in. Potentially, they could lose the premium they paid to purchase the put if the option expires. They could also lose out on upside gains if they exercise and sell the stock.
- Cash-Secured Put: Investor B, who wrote a cash-secured put to Investor A, risks the loss of their premium collected if Investor A exercises and risks the full cash deposit if the stock is "put to them."
- Naked Put: Suppose Investor B instead sold Investor A a naked put. Then, they might have to buy the stock, if assigned, at a price much higher than market value.
- Naked Call: Suppose Investor B sold Investor A a call option without an existing long position. This is the riskiest position for Investor B because if assigned, they must purchase the stock at market price to make delivery on the call. Since the market price can be infinite in the upward direction, Investor B's risk is unlimited.
What Is a Strike Price?
The strike price on an options contract is the price at which the underlying security can be either bought or sold once exercised.
Why Do Investors Use Options Contracts?
Options contracts allow buyers to gain exposure to a stock for a relatively small price. They can provide substantial gains if a stock rises, but can also result in a total loss of the premium if the call option expires worthless due to the underlying stock price failing to move above the strike price.
What Determines the Price of an Option?
Options prices commonly depend on the market price, strike price, time to expiration, interest rates, and market volatility.
The Bottom Line
Options contracts are considered risky due to their complex nature, but investors who know how options work can reduce their risk. Various risk levels expose investors to loss of premiums, gains, and market value loss.
