Don't know a put from a call?
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Adam Zoll is an assistant site editor with Morningstar.com.
Question: I often hear people who invest in options refer to puts and calls. Can you explain what they are and why an investor would buy or sell one or the other?
Answer: For more sophisticated investors, options can be a good way to accomplish goals that investing in a security directly cannot. Options may be used to provide exposure to an area of the market at a lower cost than buying a security outright, to hedge risk, or to provide income, among other uses.
Options-based strategies can be rather complex. Your local library or bookstore probably has entire volumes on the subject. But at the very least we can help clarify what some basic options-investing terminology means, including puts and calls.
Before going any further let's clarify just what an option is. In a nutshell, the owner of an option has the right, though not the obligation, to buy or sell an asset at a set price and for a set time period.
Options are traded in the form of contracts and are applied to everything from stocks, bonds, and ETFs (exchange-traded funds) to indexes, currencies and commodities. Options are a form of derivative in that their value is derived from the value of an underlying asset.
Selling the right to buy, buying the right to sell
Now on to puts and calls. A put option gives its owner the right to sell the underlying asset at a set price while a call option gives its owner the right to buy the underlying asset at a set price. (One way to remember this distinction is to visualize the seller putting an item to be sold on a table and a buyer calling for, or requesting, the item.)
Complicating matters is the fact that puts can be bought and sold just as calls can be bought and sold. To help clarify what buying and selling puts and calls means, here's a breakdown:
Buying a put: Purchasing the right to sell an asset at a set price
Selling a put: Agreeing to buy the asset at the set price if the option is exercised
Buying a call: Purchasing the right to buy an asset at a set price
Selling a call: Agreeing to sell the asset at the set price if the option is exercised