What are call and put options?

What is options trading?

Options are contracts that give you the right to take a specific action in the future, if it'll benefit you. Options trading can allow investors to hedge existing investments from potential downturns or speculate on the price movements of stocks, exchange-traded funds (ETFs), and indexes.

Before you can even begin trading options, you'll need to get approved for an options trading account by your brokerage. Keep in mind that the potential for high returns comes at the risk of significant losses—so having a trading plan and staying informed about market conditions is crucial.

How does options trading work?

Options are primarily traded through brokerages, which act as intermediaries between buyers and sellers. An options trading account allows you to access the options market, where you can buy and sell contracts. The terms of these transactions are set in stone at the time of the contract.

Here are some key terms to understand before trading options:

American-style options. Most options contracts, including all stock and ETF options, are American style, meaning you can exercise them at any time before or on the expiration date.

European-style options. European-style options can only be exercised at expiration. It's important to note that most, but not all, index options are European style.

Opening transaction. The action taken to enter an option contract.

Closing transaction. The action taken to exit an option contract.

Premium. The cost of the option. If you're buying, it's the price you pay; if you're selling, it's what you receive.

Strike price. The predetermined price at which you can buy or sell the underlying asset.

Expiration date. The deadline by which you must decide whether to exercise your option. Once this date passes, the option becomes void, and you lose the premium you paid.

Expiration auto-exercise. Typically, options that are in the money by at least $.01 are automatically exercised through the Options Clearing Corporation.

In the money (ITM). A call option is considered ITM if the current price of the underlying stock is higher than the strike price. For a put option, it means the current price of the underlying stock is lower than the strike price.

Out of the money (OTM). A call option is considered OTM if the current price of the underlying stock is lower than the strike price. For a put option, it means the current price of the underlying stock is higher than the strike price.

At the money (ATM). A call or put option is considered ATM when the option contract strike price equals the price of the underlying security.

When you buy an option, you're the one who decides if you want to exercise the option before it expires. If exercising it will cause you to lose money, you can simply let it expire. That way, the only money you'll lose is what you spent on the option itself.

Call and put options explained

There are 2 major types of options: call options and put options.

Call options

When you buy a call option, you're buying the right to purchase a specific security at a locked-in price (the strike price) sometime in the future, or looking to capitalize on an increase in the underlying stock or index value. If the price of that security rises, you can make a profit by exercising the call contract and selling the stock at a higher market price or by selling to close the call for a potential gain.

Buying call options can provide access to potential stock or index price fluctuations using a small amount of capital. If the stock price doesn't rise as expected—and it doesn't make sense to exercise the option—you lose the premium you paid.
 

Put options

When you buy a put option, you're buying the right to sell a specific security at a locked-in price sometime in the future.

If the price of that security falls, you can potentially make a profit by exercising the contract and buying the security at the lower market price, or by selling to close the contract for a potential gain.

Buying put options can be useful when you own a stock that you believe might decline in value but don't want to sell immediately. On the other hand, if the stock price doesn't decrease as expected, the amount paid for the put could be worth less than the purchase price.

Understanding option writing

When you write an option, you're agreeing to buy or sell an underlying asset at a specified price within a certain time frame. As an option writer, you receive a premium from the buyer, which can be a source of income or a way to hedge your existing positions. However, this premium comes with an obligation—if the buyer decides to exercise the option, you must fulfill the terms of the contract. This can lead to significant gains or losses depending on market conditions.

Covered vs. uncovered options

Covered options leverage the shares of existing stock holdings in your portfolio. On the other hand, uncovered¹ (or "naked") options don't have the underlying shares—or enough money—to back them. They're riskier than covered options because they potentially expose you to unlimited losses.

How are put and call options taxed?

The IRS treats gains from options trading as either short-term or long-term capital gains, depending on how long you held the option before exercising it. If you held the option for less than a year, any profits are considered short-term capital gains and are taxed at your ordinary income tax rate. If you held it for more than a year, any profits are considered long-term gains. Long-term capital gains tax rates are typically 0%, 15%, or 20%, depending on your income level and filing status.

Writing (or selling) options can also generate taxable income. When you write a call option, you receive a premium from the buyer. This premium is considered taxable income in the year you receive it, regardless of whether or not the option is exercised. If the option is exercised—and you're required to sell the underlying asset—your capital gain or loss is determined by adding the strike price and premium received, then subtracting the cost basis.

The same principle applies to writing put options. The premium you receive is taxable income. If the option is exercised and you’re required to buy the underlying asset, the purchase price plus the premium will affect your cost basis. This determines your capital gain or loss when you eventually sell it.

Learn more about trading options

Options trading is a strategy some investors choose to incorporate into their portfolios, but it's important to recognize and understand the additional risks and complexity associated with puts and calls. Remember, you'll have to get preapproved before you can trade options.

Learn more about trading options from OCC

Find out how to get approved to trade options at Vanguard