Options are a popular and versatile type of financial derivative that gives traders the flexibility to hedge their portfolios, generate income, and speculate on market movements.

For example, one type of option can be used to participate in the upside potential of an underlying asset while limiting the downside risk, while another type of option can be used to protect against a decline in the value of an underlying asset.

Let’s explore what options are, their basic components, and the key concepts that every market participant should know before trading or investing in options.

What is an Option?

An option is a financial contract that grants the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price, known as the strike price, on or before a predetermined expiration date.

The underlying asset can be a stock, bond, commodity, currency, index, or another financial instrument.

There are two main types of options:

  1. Call Option: A call option gives the buyer the right to purchase the underlying asset at the strike price before the contract expires. Investors and traders typically buy call options when they anticipate an increase in the asset’s price.
  2. Put Option: A put option gives the buyer the right to sell the underlying asset at the strike price before the contract expires. Investors and traders buy put options when they expect the asset’s price to decline.

What is a Call Option?

A call option gives the buyer the right to purchase the underlying asset at the strike price before the contract expires.

Call Option

  • If the buyer believes the asset’s price will rise, they can purchase a call option. If the asset’s price rises above the strike price, the buyer can exercise the option and buy the asset at the lower strike price, making a profit on the difference between the market price and the strike price.
  • If the asset’s price does not rise above the strike price, the option expires worthless, and the buyer loses only the premium paid for the option.

What is a Put Option?

A put option gives the buyer the right to sell the underlying asset at the strike price before the contract expires.

Put Option

  • If the buyer believes the asset’s price will decline, they can purchase a put option. If the asset’s price falls below the strike price, the buyer can exercise the option and sell the asset at the higher strike price, making a profit on the difference between the strike price and the lower market price.
  • If the asset’s price does not fall below the strike price, the option expires worthless, and the buyer loses only the premium paid for the option.

Components of an Option

Understanding the key components of an option is crucial for making informed decisions.

These components include:

  • Strike Price: The price at which the underlying asset can be bought or sold when the option is exercised.
  • Expiration Date: The date on which the option contract expires, and the right to exercise the option ceases to exist.
  • Premium: The price that the buyer pays to the seller (option writer) to acquire the option. The premium is influenced by several factors, such as the time remaining until expiration, the difference between the strike price and the current market price of the underlying asset, and the volatility of the asset.
  • Intrinsic Value: The difference between the current market price of the underlying asset and the option’s strike price. Intrinsic value represents the immediate profit that could be realized if the option were exercised. An option is considered “in-the-money” if it has intrinsic value, “at-the-money” if the strike price is equal to the market price, and “out-of-the-money” if it has no intrinsic value.
  • Time Value: The portion of the option premium that reflects the time remaining until the expiration date. Time value decreases as the option approaches expiration, a phenomenon known as “time decay.”

Exercising Options

When the buyer decides to exercise the option, they notify their broker, who then communicates the exercise to the option seller (writer).

In the case of stock options, the buyer can either take physical delivery of the shares or settle the option in cash, depending on the terms of the contract and the specific market practices.

Example #1: Buying a Call Option

Let’s consider a real-world example of buying a call option:

Imagine that it’s April 1st, and you believe the stock of Company XYZ, which is currently trading at $50 per share, will increase in value over the next two months.

You decide to buy a call option to potentially profit from this anticipated price increase.

You look at the available options and find a call option with a strike price of $55, an expiration date on June 1st, and a premium of $2 per share.

Each option contract typically represents 100 shares of the underlying stock, so the total cost of the option would be $200 ($2 per share x 100 shares).

Here are two possible scenarios that could play out:

  1. The stock price rises above the strike price: Let’s say that by May 20th, the stock price of Company XYZ has risen to $65 per share. Since the stock price is now above the strike price of $55, your call option is considered “in-the-money.” You decide to exercise the option and buy 100 shares of Company XYZ at the $55 strike price, for a total cost of $5,500.

You can then immediately sell the shares at the current market price of $65 per share, making a profit of $10 per share (minus the $2 premium you initially paid). Your total profit would be $800 [($10 profit per share – $2 premium per share) x 100 shares].

  1. The stock price does not rise above the strike price: Suppose that by June 1st, the stock price of Company XYZ has only increased to $53 per share. In this case, the call option would expire “out-of-the-money,” as the stock price did not rise above the $55 strike price. You would not exercise the option, and your loss would be limited to the $200 premium you paid for the option.

In this example, buying a call option allowed you to potentially profit from the anticipated price increase in Company XYZ’s stock while limiting your risk to the option premium.

Example #2: Buying a Put Option

Let’s consider a real-world example of buying a put option:

Imagine that it’s October 1st, and you believe the stock of Company ABC, which is currently trading at $80 per share, will decrease in value over the next three months. You decide to buy a put option to potentially profit from this anticipated price decline.

You look at the available options and find a put option with a strike price of $75, an expiration date on January 1st, and a premium of $3 per share.

Each option contract typically represents 100 shares of the underlying stock, so the total cost of the option would be $300 ($3 per share x 100 shares).

Here are two possible scenarios that could play out:

  1. The stock price falls below the strike price: Let’s say that by December 15th, the stock price of Company ABC has dropped to $65 per share. Since the stock price is now below the strike price of $75, your put option is considered “in-the-money.” You decide to exercise the option and sell 100 shares of Company ABC at the $75 strike price, for a total of $7,500.

Assuming you bought the 100 shares at the current market price of $65 per share, your total cost would be $6,500. By exercising the put option, you make a profit of $10 per share (minus the $3 premium you initially paid). Your total profit would be $700 [($10 profit per share – $3 premium per share) x 100 shares].

  1. The stock price does not fall below the strike price: Suppose that by January 1st, the stock price of Company ABC has only decreased to $77 per share. In this case, the put option would expire “out-of-the-money,” as the stock price did not fall below the $75 strike price. You would not exercise the option, and your loss would be limited to the $300 premium you paid for the option.

In this example, buying a put option allowed you to potentially profit from the anticipated price decrease in Company ABC’s stock while limiting your risk to the option premium

Option Writers

The sellers of options, also known as option writers, are obligated to fulfill the terms of the contract if the buyer decides to exercise the option.

In the case of a call option, the writer must sell the underlying asset at the strike price, and for a put option, they must buy the underlying asset at the strike price.

Example #3: Selling a Call Option

Let’s consider a real-world example of selling (writing) a call option:

Imagine that it’s June 1st, and you own 100 shares of Company GHI, which is currently trading at $40 per share.

You believe the stock price will either remain stable or increase slightly over the next month, and you decide to sell a call option to generate additional income from your stock position.

You look at the available options and find a call option with a strike price of $45, an expiration date on July 1st, and a premium of $1.50 per share.

Each option contract typically represents 100 shares of the underlying stock, so the total premium you receive for selling the option would be $150 ($1.50 per share x 100 shares).

Here are two possible scenarios that could play out:

  1. The stock price remains below the strike price: Let’s say that by July 1st, the stock price of Company GHI has increased to $43 per share or stayed around $40. In this case, the call option would expire “out-of-the-money,” as the stock price did not rise above the $45 strike price. The buyer of the call option would not exercise it, and you, as the option seller, would keep the entire $150 premium as profit. Additionally, you still own your 100 shares of Company GHI.
  2. The stock price rises above the strike price: Suppose that by July 1st, the stock price of Company GHI has increased to $47 per share. In this case, the call option would be “in-the-money,” as the stock price rose above the $45 strike price. The buyer of the call option could decide to exercise it, which would require you, as the option seller, to sell your 100 shares of Company GHI at the $45 strike price, for a total of $4,500.

Since you received a $1.50 per share premium when you sold the option, your effective selling price for the shares would be $46.50 per share ($45 strike price + $1.50 premium).

You would still make a profit on the stock ($6.50 per share, assuming a purchase price of $40 per share) and keep the option premium. However, you would miss out on the additional gain from the stock price increase to $47 per share.

In this example, selling a call option allowed you to potentially generate income from the anticipated price stability or slight increase of Company GHI’s stock.

However, if the stock price rises significantly, you may be obligated to sell your shares at a lower price than the current market price, potentially missing out on additional gains

Example #4: Selling a Put Option

Let’s consider a real-world example of selling (writing) a put option:

Imagine that it’s August 1st, and you believe the stock of Company DEF, which is currently trading at $120 per share, will either increase in value or remain relatively stable over the next two months.

You decide to sell a put option to generate income from this anticipated price stability.

You look at the available options and find a put option with a strike price of $115, an expiration date on October 1st, and a premium of $4 per share.

Each option contract typically represents 100 shares of the underlying stock, so the total premium you receive for selling the option would be $400 ($4 per share x 100 shares).

Here are two possible scenarios that could play out:

  1. The stock price remains above the strike price: Let’s say that by October 1st, the stock price of Company DEF has increased to $125 per share or stayed around $120. In this case, the put option would expire “out-of-the-money,” as the stock price did not fall below the $115 strike price. The buyer of the put option would not exercise it, and you, as the option seller, would keep the entire $400 premium as profit.
  2. The stock price falls below the strike price: Suppose that by October 1st, the stock price of Company DEF has dropped to $110 per share. In this case, the put option would be “in-the-money,” as the stock price fell below the $115 strike price. The buyer of the put option could decide to exercise it, which would require you, as the option seller, to buy 100 shares of Company DEF at the $115 strike price, for a total of $11,500.

Since the current market price is $110 per share, you would effectively be buying the shares at a $5 per share premium compared to the market price.

However, you received a $4 per share premium when you sold the option, so your net loss would be $1 per share ($5 premium paid – $4 premium received) x 100 shares, or $100.

In this example, selling a put option allowed you to potentially generate income from the anticipated price stability of Company DEF’s stock.

But if the stock price falls significantly, you may be obligated to buy the shares at a higher price than the market price, resulting in a loss.