What Is an Option?

An option is a contract that gives its buyer the right, but not the obligation, to buy or sell an asset at a fixed price on or before a set date. The buyer pays for that right up front. The seller receives the payment and takes on the obligation to complete the trade if the buyer chooses to use the right. Options exist on stocks, ETFs, indexes, futures, currencies and crypto.

Calls and puts#

There are two basic kinds:

• A call option gives the right to buy at the fixed price. Buyers of calls benefit when the price rises.
• A put option gives the right to sell at the fixed price. Buyers of puts benefit when the price falls.

The fixed price is the strike price, the last day is the expiration date, and the price paid for the option is the premium. In the US, one standard stock option contract covers 100 shares.

A call option example#

A stock trades at $50. You buy one call with a $55 strike expiring in two months for a premium of $1.20 per share, which is $120 for the contract.

Your maximum loss is the premium you paid, no matter how far the stock falls. Your potential gain grows as the stock rises above the strike plus the premium.

A put option example#

The same stock trades at $50. You buy one put with a $45 strike for $0.90, or $90. If the stock falls to $40 by expiration, the right to sell at $45 is worth $5.00 per share, $500 for the contract, a profit of $410. If the stock stays above $45, the put expires worthless and you lose $90. Investors often buy puts as insurance on shares they own. See Protective Put.

What decides an option's price#

The premium has two parts:

• Intrinsic value: what the option would be worth if exercised right now. A $55 call on a $60 stock has $5 of intrinsic value.
• Extrinsic value (time value): everything else, reflecting the chance the option gains more value before expiry.

Extrinsic value depends mainly on time left and on implied volatility, the market's expectation of how much the price will move. More time and more expected movement make options more expensive. As expiration approaches, time value melts away, a process called time decay. See Intrinsic and Extrinsic Value, Implied Volatility (IV) and Theta.

Buyers and sellers#

Sellers win more often, because many options expire worthless, but take on the risk of a large loss when they do not. See Exercise and Assignment.

Why people use options#

• Leverage: control 100 shares for a fraction of their price.
• Defined risk: buyers know their maximum loss in advance.
• Insurance: puts protect existing positions from large falls.
• Income: selling options, such as covered calls, collects premiums.
• Flexible views: profit from a rise, a fall, a move in either direction or a lack of movement, using combinations. See Vertical Spreads and Straddle.

Risks#

Most options bought by beginners expire worthless, often because they are far from the current price or too short dated. Options spreads are also wider than stock spreads, so using Limit Orders matters. Selling options without owning the underlying asset can produce losses far larger than the premium collected.

Options are often compared with futures, which oblige both sides to trade; see Futures vs Options for a side by side comparison.

Frequently asked questions#

Are options riskier than stocks?#

Buying options limits your loss to the premium, but you can lose all of it quickly. Selling options can carry large risk. Options also lose value with time, which stocks do not.

What happens if I do not exercise my option?#

If it is out of the money at expiration, it simply expires worthless. Many brokers automatically exercise options that are in the money by a small amount at expiration, so check your broker's rules.

What is the difference between American and European options?#

American options can be exercised any time before expiration; European options only at expiration. Most US stock options are American style. See American vs European Options.

Sources#

• The Options Clearing Corporation, Characteristics and Risks of Standardized Options
• U.S. Securities and Exchange Commission, Options