Options Basics
Calls and puts, strike, premium and expiration, intrinsic and time value – how options work, what drives their price and why buyers and sellers carry completely different risks.
Key takeaways
- An option gives the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a fixed strike price.
- For that right, the buyer pays a premium to the seller (writer). The buyer’s maximum loss is the premium.
- An option’s price consists of intrinsic value and time value. Time value melts to zero by expiration.
- The price is driven mainly by the underlying’s price, the strike, time to expiration and expected volatility.
- Options can hedge or speculate. Sellers of uncovered options can face unlimited risk.
Options are among the oldest and most versatile financial instruments. Farmers hedged harvests with option-like contracts in antiquity, and today millions of contracts trade every day on exchanges such as Cboe. Options can insure a portfolio against a crash, generate income or bet on big moves with a small stake. But you have to understand their mechanics precisely.
A right, not an obligation
An option is a contract between two parties:
- The buyer (holder) acquires the right to buy or sell an underlying asset – typically 100 shares – at a fixed price until or on a certain date.
- The seller (writer) takes on the obligation to deliver or take delivery if the buyer wants.
- For the right, the buyer pays the seller a premium.
There are two basic types:
| Call | Put | |
|---|---|---|
| Buyer’s right | buy at the strike | sell at the strike |
| Buyer profits when | the price rises | the price falls |
| Typical use | bet on rising prices | hedge a portfolio, bet on falling prices |
Key terms:
- Strike price: the fixed buy or sell price.
- Expiration: the last day the option can be exercised. American-style options can be exercised any time before expiration (most US stock options); European-style only at expiration (most index options).
- Contract size: a US equity option contract usually covers 100 shares, so a quoted premium of $5 costs $500 per contract.
The payoff profile
At expiration an option is either worthless or worth exactly how far it is “in the money”. For a call with a $100 strike:
That asymmetry is the core of every option: the buyer risks at most the premium but can win a lot. The seller collects the premium for sure but can lose a lot. Which side does better depends on whether the premium fairly priced the swings that actually occur.
Intrinsic value and time value
An option’s price has two parts:
- Intrinsic value is what the option would be worth if exercised immediately. A call with a $100 strike on a $110 stock has $10 of intrinsic value.
- Time value is the extra paid for the chance that the price moves favourably before expiration. It’s higher the longer the time remaining and the higher expected volatility.
Depending on the stock price relative to the strike:
| Term | Call | Put | Intrinsic value |
|---|---|---|---|
| In the money | price > strike | price < strike | positive |
| At the money | price ≈ strike | price ≈ strike | ≈ 0 |
| Out of the money | price < strike | price > strike | 0 |
Time value melts every day – slowly at first, then faster and faster near expiration. At expiration it’s zero. This time decay works against the buyer and for the seller.
What drives an option’s price
In 1973, Fischer Black and Myron Scholes – with Robert Merton – published a model for pricing options that transformed finance (Scholes and Merton won the 1997 Nobel Prize). Under the Black-Scholes model, an option’s price depends on five factors:
| Factor | Effect on call | Effect on put |
|---|---|---|
| Underlying price rises | more expensive | cheaper |
| Higher strike | cheaper | more expensive |
| More time to expiration | usually more expensive | usually more expensive |
| Higher expected volatility | more expensive | more expensive |
| Higher interest rates | slightly more expensive | slightly cheaper |
The only factor you can’t observe directly is expected volatility. Conversely, you can back out from option prices what volatility the market expects – the implied volatility. The VIX is based on it.
Deep dive · The "Greeks"
Professionals measure an option’s sensitivities with figures named after Greek letters:
- Delta: how much does the option price change when the underlying rises by $1? An at-the-money call has a delta of about 0.5.
- Gamma: how fast does delta change?
- Theta: how much time value does the option lose per day?
- Vega: how strongly does the price react to a change in volatility?
What options are used for
- Hedging: owning stock and buying a put gives you insurance against losses below the strike – for a premium, like any insurance.
- Income: owning stock and selling calls on it earns premiums, but gives up gains above the strike (covered call).
- Speculation: buying options lets you bet on big moves with a small stake. Because many options expire worthless, it’s a tough game.
Summary
Options give the buyer a right and the seller an obligation – in exchange for a premium. Calls profit from rising prices, puts from falling ones. The price consists of intrinsic and time value and depends mainly on price, strike, time and volatility. In the next lesson we combine options into strategies, and the calculator shows how differently their risks and rewards are shaped.
Time to practise
13 short exercises on this lesson – mistakes come back at the end. Then the lesson is complete and joins your review queue.
Test your knowledge
0/401You buy a call with a $100 strike for a $5 premium. At expiration the stock is at $112. What’s your profit per share?
02A stock trades at $50. A put with a $55 strike costs $7. How is that price made up?
03What happens to an option’s price if expected volatility rises (all else equal)?
04Who carries the biggest risk when an uncovered call is sold?