Should you buy a call or put option?

12 September 2022 by Montreal Exchange
Investors see their drips and dividends growing up.

Investors owe it to themselves to study and develop their own individual investment strategy, especially in the options market that might seem more complex compared to buying shares.

Understanding the Dividend Reinvestment Plan

Learn more about the difference between shares and options in this article.

One investor might find it suitable to buy put options which offer downside protection should the underlying stock position lose value (aka: Protective Put Strategy). Meanwhile, another investor would look to take a position on the other side and buy call options to generate a return if the underlying stock gains in value.

In this example, the first investor is using options to protect against a potential bear market defined by falling equity prices. This strategy proved particularly useful to investors in 2022 when a multi-year long bull market came to an end.

By contrast, the second investor is using options to take advantage of a bull market where stocks gain in value. Similarly, this strategy likely proved to be effective for investors prior to 2022 when markets reacted to the war in Ukraine, and soaring inflation, among several other concerning negative catalysts.

What are put options for?

Put options help investors take on a bearish view on a stock. The trade allows the put holder the right to sell the stock at a fixed price should the share price tumble. However, if the investor is already holding the stock in the portfolio and buys a put option, this is called a protective put option strategy and is meant to protect against losses – similar to an insurance policy.

What actions should be taken after purchasing put options ?

In the case of the first investor who takes advantage of put options while protecting their investments, there are two ways their position can play out: the underlying equity goes up or down in price.

Value of the stock goes up: get rid of the put option (or let it expire)

Should the value of the stock go up, the investor would expect the value of the protective put option to lose in value. They can look to sell the stock and pocket a profit and attempt to also get rid of the put option, provided it has any remaining premium attached to the price.

Value of the stock goes down: hold the put option (or exercise the put option)

If the underlying shares fall in value, the put options will appreciate in value and partially or fully offset any losses. Investors may want to consider holding the position until the expiry date approaches. On the other hand, if they no longer believe in the fundamentals of the company, they can exercise the put option to sell the stock at the exercise price.

What are call options for?

A call option strategy is designed to generate a profit and build the total value of a portfolio because it gives the call buyer the right to buy the underlying stock at the strike price. Thus, allowing investors a tool if their forecast is bullish on the company.

To learn more about call options, read this article.

What to do following call options purchase?

Stock value goes down : Consider adding option contracts or take a loss

If a holder of a call option sees the underlying stock lose in value, their investment will most likely lose value. At this point, the investor could consider adding to their position by buying additional option contracts. The logic being that the investor believes the market is wrong and the stock should bounce back quickly.

The second option is to take a loss on the call option. In this case, the investor acknowledges their trade thesis failed to play out as expected and prudent risk management practices need to be respected.

When stock value goes up?

This is the optimal scenario for any call buyer. The investor can close the option position at a profit or exercising the call option. When investors exercise a call option, they need to have sufficient funds to acquire the stock at the strike price. Otherwise, selling the option position is perfectly fine as well.

Comparing a call and a put

The bottom line is that it is important to understand your investment thesis because this determines what actions, and which options strategy, you must take as time passes.

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Key takeaways

  • A protective put option strategy is meant to protect against losses – similar to an insurance policy.
  • In the case of the first investor who takes advantage of put options, there are two ways their position can play out: the underlying equity goes up or down in price.
    • Stock goes up: get rid of the put option
    • Stock goes down: hold the put option
  • A call option strategy is designed to generate a profit and build the total value of a portfolio.
    • Stock goes up: one can either sell the call for a profit or exercise the option.
    • Stock goes down: the call option will lose value and will likely expire worthless if the stock does not rebound.
  • The bottom line is that it is important to understand your investment thesis because this determines what actions, and which options strategy, you must take as time passes.

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