Introduction to Options

Options are contracts that give their owners the right to buy or sell the underlying asset (but not the obligation). The value of an option depends on the price of the underlying security (such as a stock). Option contracts may allow their owners to buy 100 shares of the underlying asset ("call options") or sell 100 shares of the underlying asset ("put options").

You can also profit from options trading by buying and selling contracts, which is the most common way traders attempt to profit from options trading. Options typically become worthless in the opposite direction, so you should understand their risks before investing. Also, note that some complex options could lead to significant losses in the original trade.

How do options work?

Options are essentially legal contracts— they grant jurisdiction and require the contractor to do certain things. According to the option contract, getting the right to buy or sell involves paying a premium. A certain price is paid to purchase the underlying stock until a certain counter-date to exercise the rights under the contract.

Here are some key terms:

Premium: The buyer of an option pays the premium to the seller— that is, the price of the option. Premiums are usually quoted in contract prices, but since most contracts represent 100 shares of the underlying security, you typically need to pay a premium 100 times the cost of one contract. For example, if the premium for an option is $1.00, you will need $100 to purchase it. Strike Price: This is the price at which the seller is obligated to buy or sell during the contract period.
Expiration Date: Each contract has an expiration date, which is the date the contract is exercised and trading stops. For stock options, the "standard" expiration date is typically the third Friday of the contract's ending month. However, there are also "non-standard" options expiring weekly, which might be on days other than Fridays for certain products.

Call Options and Put Options

Options come in two types: call options and put options.

Call options allow the owner to purchase a specific asset at a specific exercise price before a specific date.
Put options allow the owner to sell a specific asset at a specific exercise price before a specific date.
In-the-Money, At-the-Money, Out-of-the-Money

Options can be in-the-money, at-the-money, or out-of-the-money.

In-the-Money: The exercise price of the option is below the price of the underlying asset for call options or above the price of the underlying asset for put options.
At-the-Money: The exercise price of the option is equal to the price of the underlying asset.
Out-of-the-Money: The price of the underlying asset is above the exercise price for call options or below the exercise price for put options.
For call options, the value of the contract typically increases as the price of the underlying asset rises.

For put options, the value of the contract typically increases as the price of the underlying asset falls.

However, there are other important factors affecting the price of options.

How much is an option worth?

The value of an option is reflected in its price, which retail investors will see on trading platforms. An option has two components:

Option Price = Intrinsic Value + Time Value

Intrinsic Value: This is the amount of the option's actual value. For example, if a stock is trading at $55, and the exercise price of a call option is $50 with a premium of $7, the option will have an intrinsic value of $5 ($55 stock price - For put options, it's the opposite. Using the same stock priced at $55, a put option with a $60 exercise price would have $5 of intrinsic value.
Intrinsic value means that buying or selling the stock at the exercise price would result in intrinsic gain relative to the current market value. However, having an option with intrinsic value does not necessarily mean that you should or must exercise it.
Time Value: Time value is the portion of an option's price that is near the end of its value time. The longer the time remaining until expiration, the more time the option has to potentially move into a profitable state. Thus, options with longer-term horizons typically have higher time values implied compared to those with shorter-term horizons.
Implied Volatility: Often one of the hardest concepts for new option traders to grasp, but can significantly impact option prices. The greater the volatility of a stock (the range of prices over a certain period), the greater the chance that out-of-the-money options will move into the money, so implied volatility is the volatility expectation expressed in option premiums. Because it's implied from option prices, it's referred to as implied volatility. If traders anticipate a stock to be volatile, the expected volatility of the option will be higher. Prices will be higher. If traders believe that the stock price will remain stable, options tend to be cheaper. However, like any crystal ball or right indicator, it can sometimes be wrong. Note that implied volatility is always fluctuating, increasing or decreasing the value of the option, unrelated to the direction of the underlying stock (whether it's going up or down).

What can owners do?

If you own an option, you can take the following actions:

Sell before expiration: The value of options changes every day, mainly driven by the price of the underlying stock, expiration time, and implied volatility (among other factors). This change in value can be reflected in the premium, and you can submit an order to sell the option before your option is due for expiration. The difference between the price you bought the option for and the price you sell it for is your profit or loss, which is the most common way to close options positions.
Exercise before expiration: American-style options can typically be exercised at any time prior to expiration, where usually you would only exercise the option when it is "in the money," and you wish to purchase (in the case of call options) or sell (in the case of put options) the underlying stock (assuming you have the cash to purchase 100 shares of the underlying stock or already own 100 shares of the underlying stock).
Allow expiration: If an option is facing its out-of-the-money status, most brokers will automatically remove that position from your account over the upcoming weekend.
Rolling: The process of closing an existing position and immediately establishing a new one on the same day, sometimes using different strikes. While some traders use this to "extend the duration of the trade," ultimately you'll be closing out one position, realizing any gains or losses, and establishing a new position.
Note: Your brokerage firm likely has policies in place where if the option is worth $0.01 or more in actual value on the day before expiration, they may exercise it on your behalf.

Also, be aware of any options hovering around the strike price of your underlying stock at expiration. You might think the option is about to become worthless, but trading activity before and after market close could turn your option into one that will cause you to be assigned, known as "pin risk." The best way to avoid pin risk is to close out any options that may have the chance of moving into an in-the-money status before market close.

Risks of Option Investing

You can be on the offensive or the selling side.

As a holder of options, your theoretical risk is limited to the premium paid. The worst-case scenario is that the option expires worthless, and you lose the entire amount paid for the option. The best-case scenario is that the option moves into the money, and you make a profit by selling it.

As the seller of options, your risk is more open. If you sell a contract, you hope it expires worthless. In this case, your profit is the premium collected from selling the option. If you're assigned the option, you'll have the obligation to buy or sell the stock, thus taking on more risk.

If you sell call options, your potential loss is unlimited, as the stock price can rise indefinitely. If the stock rises significantly, you're obligated to sell the stock at the exercise price to the holder of the option. While you've made some money by selling the option (the premium), if you have to sell the stock at a much lower price than its market value, you could lose more. If you sell put options, your potential loss is limited to the difference between the exercise price of the put option and the amount you received for selling the put option. Because the stock price can drop to zero, but as the seller of the put option, you're obligated to buy the stock at the exercise price from the holder of the put option (adjusting for the portion of the premium initially collected).

It's important to note that as the seller of options, your risk can be unlimited if you sell call options, and your risk can be significant if you sell put options. As the buyer, your risk is having your option expire worthless and losing the entire premium paid, with no return. Your potential risk changes as well if you're assigned long options for free or assigned short options, as you now own or are short the stock.

Options trading can involve high risk and may not be suitable for all investors, and some complex option strategies can carry additional risks. Investors should carefully consider their investment objectives and risks before engaging in options trading.

How to Buy Options?

Retail investors can obtain options through brokerage firms.

To purchase options, you pay a premium, which is the cost of the option (premiums are usually quoted in per-share prices, but are sold in contract form representing 100 shares of the underlying asset). So, a $0.30 premium will cost $30, as this is advantageous to purchase or the right to buy or sell 100 shares of the underlying asset).

Options Uses

Hedging: For example, if you believe the price will rise, you may buy stocks, but this prediction is not foolproof. To mitigate losses in case of a price drop, you may buy put options, helping to determine your maximum loss on the investment. Meaning there are multiple strategies and methods to utilize options to hedge risks in a portfolio, buying put options being just one of them.
Generating Income Again: You can sell options (or option spreads) to generate additional income, which is the premium you save. However, the options sold may appreciate, leading to losses or assignments. Restarting puts you at risk of doing more long or short stock.
Speculation: You may believe a stock will rise or fall over a period of time. You can buy call options or put options (and other strategies) instead of buying or selling stocks. The upfront cost of purchasing options is typically less than owning or shorting stocks directly, but is generally considered a lower probability strategy with less favorable odds of profitability.