How Options Work

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 fixed date. The buyer pays a price, called the premium, for that right. The seller receives the premium and takes on the obligation to complete the trade if the buyer chooses to use the option. This lesson walks through how the pieces fit together; the short overview is in What Is an Option?, and a full route through the topic is in the Options Learning Path.

The parts of an option#

A simple example#

Buyers and sellers#

Every option has two sides:

Selling options earns premium income but carries obligations and potentially large losses. See Short Call and Short Put.

What determines an option's price#

An option's premium depends mainly on:

1. The underlying price relative to the strike. See Moneyness: ITM, ATM and OTM.
2. Time to expiration: more time means more chance of a favourable move.
3. Volatility: bigger expected moves make options more valuable. See Implied Volatility (IV).
4. Interest rates and dividends, which have smaller effects.

The premium splits into intrinsic value, what the option would be worth if used now, and extrinsic value, the extra paid for time and uncertainty. See Intrinsic and Extrinsic Value.

How options end#

An option can end in three ways:

• Sold or bought back before expiration. Most option positions are closed this way.
• Exercised: the holder uses the right to buy or sell the underlying. See Exercise and Assignment.
• Expire worthless if it has no intrinsic value at expiration.

Why traders use options#

• Leverage: control a large position with a smaller outlay.
• Defined risk: buyers know their maximum loss up front.
• Hedging: protect a portfolio against falls. See Protective Put.
• Income: sell options to collect premium. See Covered Call.
• Trading volatility: profit from the size of moves rather than direction. See Volatility Trading.
• Building custom payoffs with combinations. See Option Payoff Diagrams.

The risks#

• Time decay: options lose value as expiration approaches, all else equal. See Theta.
• Total loss for buyers when options expire worthless.
• Large losses for sellers, especially of uncovered calls.
• Complexity: prices respond to several factors at once. See The Option Greeks Explained.
• Liquidity: less active options have wide bid ask spreads.

Where options trade#

In the United States, listed stock and index options trade on exchanges such as Cboe and Nasdaq and are cleared by the Options Clearing Corporation, which guarantees each contract. Options also trade on futures, currencies and crypto on various exchanges. To trade options, brokers usually require approval for different strategy levels.

Frequently asked questions#

How do options work in simple terms?#

An option is a contract that lets you buy (call) or sell (put) an asset at a set price before a set date. You pay a premium for that right.

Can you lose more than you invest with options?#

Option buyers can lose at most the premium paid. Option sellers can lose much more, and uncovered call sellers face losses with no upper limit.

Why are options contracts for 100 shares?#

US stock options are standardised so that one contract covers 100 shares, which is why a quoted premium of $2.00 costs $200 per contract.

Next, learn the two basic types in Calls and Puts.

Sources#

• Options Industry Council, Options education
• Wikipedia, Option (finance)