Options

What is an option

An option is a contract. It gives the buyer the right to buy or sell an asset at a set price before or on a set date. The buyer can choose to exercise that right. The seller of the option must follow through if the buyer exercises.

Options are a kind of derivative. Their value comes from something else, usually a stock, an index, a commodity, or an ETF.

There are two main types:

• Call: the right to buy the underlying asset.
• Put: the right to sell the underlying asset.

Main pieces of an option

• Underlying: the asset the option is based on. For example, one share of stock.
• Strike price: the price at which the asset can be bought or sold.
• Expiration: the date the option expires.
• Premium: what the buyer pays the seller for the option.
• Contract size: how many units one option covers. For US stock options one contract normally covers 100 shares.
• Exercise style: American options can be exercised anytime before expiration. European options can be exercised only at expiration.

How value works

An option's price has two parts.

• Intrinsic value: how much the option would be worth if exercised now.
  • Call intrinsic = max(0, stock price minus strike).
  • Put intrinsic = max(0, strike minus stock price).
• Time value: the extra amount buyers pay for the chance the option will become more valuable before expiration. Time value goes down as expiration approaches.

Implied volatility affects time value. If investors expect big price swings, premiums rise.

Simple example

You buy a call on stock XYZ:

• Strike = $50
• Premium = $2 per share
• Contract covers 100 shares
• Expiration = 1 month

Scenarios at expiration:

• Stock at $60. Call intrinsic = $60 - $50 = $10. You paid $2, so profit per share = $10 - $2 = $8. Total profit = $800.
• Stock at $52. Intrinsic = $2. Profit per share = $2 - $2 = $0. You break even.
• Stock at $48. Intrinsic = $0. You lose the premium $2 per share. Total loss = $200.

Buyers risk only the premium. Sellers of uncovered calls risk large losses if the stock jumps.

Why use options

• Hedging. Protect a stock position from a drop by buying puts.
• Speculation. Use options to bet on price moves with less capital than buying the stock.
• Income. Sell covered calls to collect premiums on a stock you own.
• Leverage. Small premium controls a larger position, magnifying returns and losses.
• Flexibility. You can combine options into strategies that profit from moves, lack of moves, or volatility changes.

Common strategies

• Long call: buy a call to profit from a rise.
• Long put: buy a put to profit from a fall or to hedge.
• Covered call: own stock and sell call to earn premium.
• Protective put: own stock and buy put to limit downside.
• Straddle: buy both a call and put at the same strike to profit from big moves either way.
• Spread: buy and sell options at different strikes or expirations to limit risk and cost.

Risks and realities

• Premium is lost if option expires worthless.
• Sellers can face large or unlimited losses if positions are naked.
• Assignment can happen any time for American options. Sellers may be forced to deliver or buy stock.
• Time decay works against buyers. The closer to expiration, the faster the time value drops.
• Transaction costs and margin rules matter. Trading many small contracts can be expensive.
• Options are complex. Some strategies change value quickly as the underlying moves.

The Greeks in one line each

These are tools that show how an option price changes.

• Delta: change in option price for a small move in underlying.
• Theta: change in option price as time passes.
• Vega: change in option price for a change in volatility.
• Gamma: how fast delta changes as the underlying moves.

Quick FAQ

• Are options only for stocks? No. Options exist on indexes, ETFs, commodities, and even interest rates.
• Do I have to buy 100 shares? If you buy one standard option contract, it represents 100 shares. Mini contracts exist for some underlyings.
• Are options only for pros? No. Retail investors can trade options, but they should learn and use small positions until they understand the risks.
• How taxed are options? Taxes depend on the country and how the option was used. Check local rules.

Final thought

Options let you turn a view on price into a trade that fits your risk and capital. They offer power and flexibility. They also punish carelessness. Learn the parts, use small tests, and treat volatility and time as part of the game.