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How Do Calls and Puts Work: A Comprehensive Guide

January 5, 2024
Reading Time: 3 minutes

The domain of trading calls and puts allows investors to adopt diverse strategies to capitalise on market movements. This comprehensive guide aims to delve deeper into the concepts of calls and puts, exploring their intricacies, types, strategies, pros and cons, and their integration with algorithmic trading. Read on to learn more. 

Understanding Calls and Puts

Calls

A call option gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (strike price) within a specified period (until expiration).

Buyers of call options expect the underlying asset’s price to rise, enabling them to profit from buying at a lower strike price than the market value.

Example 

Suppose an investor purchases a call option on a stock priced at ₹1,000 with a strike price of ₹1,050, paying a premium of ₹40 per share for a contract size of 100 shares. 

  • If the stock’s price rises to ₹1,120 by expiration, the investor can exercise the option, buying the shares at the strike price (₹1,050) and selling them in the market for ₹1,120, earning a profit of ₹70 per share (₹1,120 – ₹1,050 – ₹40 premium). 
  • Conversely, if the stock price remains below the strike price at expiration, the investor’s option expires worthless, resulting in a loss limited to the premium paid.

Puts

A put option grants the holder the right, but not the obligation, to sell an underlying asset at a predetermined price (strike price) within a specified timeframe (until expiration).

Buyers of put options anticipate the underlying asset’s price to decrease, allowing them to profit by selling at a higher strike price than the market value.

Example

Suppose an investor purchases a put option on a stock priced at ₹800 with a strike price of ₹750, paying a premium of ₹30 per share for a contract size of 200 shares.

  • If the stock’s price declines to ₹700 by the expiration date, the investor can exercise the put option, selling the shares at the strike price (₹750) instead of the lower market price of ₹700, resulting in a profit of ₹50 per share (₹750 – ₹700 – ₹30 premium) on 200 shares, totalling ₹10,000.
  • However, if the stock’s price rises above the strike price (₹750) at expiration, let’s say to ₹780, the investor’s put option expires worthless. In this scenario, the investor faces a loss limited to the premium paid (₹30 per share × 200 shares = ₹6,000), as they would not exercise the option to sell at a lower price when the market price is higher.

Mechanics and Strategies

Buying and Selling Calls/Puts

  • Buyers: They aim to profit from price movements by purchasing calls (anticipating an increase) or puts (anticipating a decrease) and can exercise these options if profitable.
  • Sellers (Writers): They receive premiums and take on obligations – selling calls obligate them to sell the asset if exercised, while selling puts obligates them to buy the asset if exercised.

Strategies Using Calls and Puts

Covered Calls and Protective Puts

  • Covered Calls: Investors hold the underlying asset and sell call options to generate income from premiums.
  • Protective Puts: Investors buy put options to protect their portfolio from potential downside risk.

Straddles, Strangles, and Spreads

  • Straddle Strategy: Buying call and put options with the same strike price and expiration, anticipating significant price volatility.
  • Strangle Strategy: Buying call and put options with different strike prices but the same expiration date, expecting price fluctuations.
  • Spreads (Bull/Bear): Strategies involving simultaneous buying and selling of options to limit risk or capitalise on price movements.

Pros and Cons

Pros

  • Flexibility: Provides diverse strategies for speculation, hedging, and income generation.
  • Limited Risk: Allows for predefined risk exposure with the premium paid or received.
  • Leverage: Offers potential high returns relative to the initial investment.

Cons

  • Limited Lifespan: Options have expiration dates, limiting their time to profit.
  • Complexity: Strategies can be intricate, requiring careful understanding and monitoring.
  • Risk of Loss: Involves the potential loss of the entire premium paid.

Algo Trading and Options

The combination of algo trading platforms, like uTrade Algos, and options has transformed the financial landscape. Algo trading, initially prominent in equities, swiftly extended into options trading due to its speed, efficiency, and risk management capabilities. This fusion brings various advantages, including rapid execution, enhanced risk control, and the ability to execute diverse strategies.

Advantages

  • Speed and Efficiency: Algorithms execute options trades swiftly, seizing fleeting market opportunities and optimising trade entries and exits.
  • Risk Management: Algo strategies incorporate risk parameters, enabling automated risk control through mechanisms like stop-loss orders and diversification.
  • Diversified Strategies: Algo trading platforms facilitate numerous strategies, from directional plays to complex multi-leg strategies, enabling traders to capitalise on diverse market scenarios.

Algo Trading Strategies in Options

  • Delta-Neutral Strategies: Aim to be insensitive to small price movements in the underlying asset, maintaining balance during call and put options trading.
  • Volatility Trading: Algorithms capitalise on volatility changes, benefiting from both increasing and decreasing volatility through strategies like straddles and strangles.
  • Option Market Making: Algorithms provide liquidity by quoting bid and ask prices continuously, profiting from the spread.

Challenges

  • Technological Complexity: Requires sophisticated technical expertise for development, maintenance, and compliance.
  • Risk of Technical Glitches: Reliance on technology poses the risk of system failures, connectivity issues, or data errors.
  • Market Dynamics: Algorithms need adaptability to navigate changing market conditions influenced by various factors.

In conclusion, call and put option trading offers investors a myriad of strategies to manage risk, speculate on market movements, and diversify portfolios. Integrating these tools with algorithmic trading, on platforms like uTrade Algos, can enhance efficiency, speed, and risk management, but investors must carefully comprehend their mechanics, assess strategies, and manage risks effectively when venturing into this dynamic realm.

Frequently Asked Questions

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uTrade Algo’s proprietary features – Advanced Strategy form,  fastest back testing engine,  Pre-made strategies help you Level up your Derivatives Trading experience

The dashboard is a summarized view of how well your Portfolios are doing, with fields such as Total P&L, Margin Available, actively traded underlyings, Portfolio name and respective underlyings, etc. Use it to quickly gauge your strategy performance

You can sign up with uTrade Algos and get started instantly. Please make sure to connect your ShareIndia trading account with us as it’s essential for you to be able to trade in the live markets. Watch this video to get started – Getting Started with uTrade Algos

While algo trading is in use for decades now for a variety of purposes, its presence has been mainly limited to big institutions. With uTrade Algos you get institutional grade features, at a marginal cost so that everyone can experience the power of algos and trade like a pro.

On uTrade Algos, beginners can start by subscribing to pre-built algos by industry experts – called uTrade Originals. 
While more advanced traders can create their own algo-enabled portfolios, with our no-code easy-to-use order form, equipped with tons of features such as – Robust risk management, pre-made strategy templates, payoff graph, options chain, and a lot more.

From single leg strategies to complex portfolios with upto 5 strategies, each strategy having up to 6 legs – uTrade Algos gives you enough freedom to create almost any strategy you’d like. What’s more is, there are pre-built algos by industry experts for complete beginners and premade strategy templates for those who want to try their hand at strategy creation.

An interesting feature that uTrade Algos is bringing to the table is a set of pre-built algorithms curated by top-ranking industry experts who have seen the financial markets inside out. These algorithms, called uTrade Originals, will be available for subscribers on the platform. 

Algos have the capability to fire orders to the exchange in milliseconds – which is one-thousandth of a second. A speed which is impossible in Manual Trading. Experience the power of Algos for free with uTrade Algos – Signup now.

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Knowledge Centre & Stories of Success

In recent developments, the Securities and Exchange Board of India (SEBI) is reportedly taking significant steps to tighten the regulatory framework around algorithmic trading and the use of Application Programming Interfaces (APIs) in the stock market. These measures aim to enhance transparency, security, and accountability in algo trading practices, which have seen a surge in popularity among retail and institutional investors alike. 

Intraday trading, also known as day trading, involves buying and selling financial instruments within the same trading day. It requires swift decision-making and a deep understanding of market dynamics. With the advent of technology, algorithmic trading has become increasingly popular among intraday traders. These automated systems execute trades based on pre-defined criteria, allowing traders to capitalise on opportunities with speed and precision. In this blog, we'll explore how to implement effective intraday trading strategies using algorithms.

In the fast-paced world of algorithmic trading, where automated systems execute pre-defined strategies in financial markets, success hinges on more than just sophisticated algorithms. To navigate this landscape effectively, traders must be aware of common pitfalls that can undermine their efforts and financial goals. In this article, we will find out how to avoid these stumbling blocks and enhance the chances of success in automated algo trading.

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