Stephen Karpin, CommSec

Question:

I understand that you buy a call when you think that the market is going up, and you buy a put when you think it is going down.

Does it mean the reverse when you sell a call and when you sell a put, ie sell call when trending down and sell put when trending up?

If so, then when the market is trending up, you either buy a call or sell a put. And when it is trending down, you either buy a put or sell a call. What then would be the difference/advantage of buying as oppose to selling an option please?

Response:

If an investor expects the share price to rise then he or she can buy a call or alternatively sell a put.  Both strategies are bullish however there are important differences between the two. The main difference is the risk/return profile of the strategy and the expected change of the underlying throughout the life of the option.

In the above example:

Someone who buys a call generally has a more bullish view of a stock than the put seller. Firstly, buying a call involves putting up capital to pay for the option.  With option buying, the most the investor can lose is the price paid for the option.  For example, if the stock does not rise by the expiry date of the option, the option buyer may then indeed end up losing all of the funds used to purchase the option.  If the stock price does rise within a reasonable time, the call option in turn may have increased in value.  Most option traders sell the option back on the market to receive their capital gain.  Alternatively, the option holder could exercise the contract and buy the underlying shares at a discount to the now higher stock price.  An investor would do this if they wanted to own the underlying and also if they thought the stock price was going to rise even more, after the expiry of the call option.

Let’s look at the case of put writing.  A put writer will receive a premium and in exchange is obliged to purchase shares off the option taker (the put buyer).  If the shares do not fall below the strike price by the expiry date, then the put will generally not be exercised.  If this is so, the put writer has no further obligation and will have profited from receiving the premium amount.  In essence, the put writer has received an insurance premium for guaranteeing against a price fall or an insured amount at which the put option buyer can exit the stock.  If the stock price rises, the maximum profit under this strategy is capped at the premium received.  If the share price falls below the strike price by expiry, the put writer is now obliged to purchase the stock.  In comparison, if the share price falls by expiry, the call buyer would only have lost the premium paid.  The put writer however has had to invest in the underlying and potentially may lose more if the share price continues to fall further.  

The 2 strategies are each undertaken with different intentions.  The put writer must be prepared to invest in the stock if they are assigned. The premium received effectively lowers the investors entry price of the stock. If the call option buyer is wrong about the stock price direction they will lose 100% of the funds invested in the call option.  This aspect of the 2 strategies can be summarised as saying the call option buyer is speculating on a price rise during the term of the option, where as the put option buyer is an investor prepared to purchase stock at a pre-determined price and perhaps has a longer term bullish view of the stock.

By Stephen Karpin, General Manager, CommSec

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Important Information
The views expressed in this article are those of Stephen Karpin, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814.  CommSec ABN 60 067 254 399 AFSL 238814 is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 23495 and a Participant of the ASX Group.
This article was produced by CommSec. Except to the extent that any liability under any law cannot be excluded, no liability for any loss or damage which may be suffered by any person, directly or indirectly, through relying upon any information or statement in this document is accepted by the Commonwealth Bank or CommSec or any of their directors, employees or agents, whether that loss or damage is caused by any fault or negligence on their part or otherwise. Commonwealth Bank and its subsidiaries do not guarantee the obligations or performance of CommSec or the products or services offered.  
As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional financial and taxation advice.  Please consider the Exchange-traded Options PDS issued by CommSec, available from www.commsec.com.au , before making any decisions.   This article does not represent a recommendation in regard to any particular company.