How markets work · Lesson 6 of 8

Options basics

Options give you a choice rather than an obligation, which makes them flexible and, for beginners, easy to misunderstand. This lesson covers the core vocabulary and explains why options that expire within days behave so differently from the shares they're based on.

Calls and puts

An option is a contract that gives its buyer the right, but not the obligation, to buy or sell an asset at a set price before or on a set date. The asset is called the underlying.

A call gives the right to buy the underlying at the set price. Call buyers benefit if the price rises.
A put gives the right to sell the underlying at the set price. Put buyers benefit if the price falls.

The set price is the strike price, and the last date the option can be used is the expiry. Using the right is called exercising the option. Options that can be exercised at any time before expiry are called American style, which covers most US stock options; those that can only be exercised at expiry are called European style.

The buyer pays the seller a price for the option called the premium. In the US, a standard stock option contract covers 100 shares, so a premium quoted at $1.50 costs $150 per contract.

Buyers and sellers

For every option buyer there is a seller, also called the writer. The buyer's maximum loss is the premium paid. The seller collects the premium up front but takes on the obligation: if the buyer exercises, the seller must deliver or take the shares at the strike price. A seller of a call who doesn't own the shares faces losses that have no fixed limit if the price keeps rising. Brokers typically require approval, at different levels, before letting a customer sell options.

What an option's price is made of

An option's premium can be split into two parts:

Intrinsic value: what the option would be worth if exercised right now. A call with a $100 strike when the stock is at $103 has $3 of intrinsic value. If the stock is below $100, the call has none. An option with intrinsic value is "in the money"; one without is "out of the money".
Time value: everything above intrinsic value. It reflects the chance that the option becomes more valuable before expiry. More time and a more volatile underlying both mean more time value.

Time value shrinks as expiry approaches, and the shrinking speeds up in the final days. This is called time decay. At expiry, time value is zero and the option is worth only its intrinsic value, if any.

Implied volatility

Volatility describes how much a price tends to move. Option pricing models take inputs such as the underlying price, strike, time to expiry and interest rates, plus an estimate of future volatility. Since everything except future volatility is known, you can work backwards from an option's market price to the volatility it implies. That figure is the option's implied volatility (IV), quoted as a yearly percentage.

High IV means options are expensive relative to normal, because the market is pricing in large moves. IV often rises before scheduled events such as earnings reports, then falls once the news is out. That fall can reduce an option's value even if the stock moves in the buyer's favour.

The Cboe Volatility Index, or VIX, applies this idea to the whole S&P 500: it is calculated from S&P 500 index option prices and expresses the market's expected volatility over the next 30 days. PYE Markets shows the VIX and similar indexes on the Markets page, labelled with their source.

Why short-dated options are hard for beginners

Options expiring within days, sometimes the same day, are cheap in dollar terms and can multiply in value on a big move. That makes them appealing. But the mechanics work against a buyer in several ways at once.

Suppose a stock is at $100. You buy one call with a $105 strike expiring in seven days for a premium of $1.00, which costs $100 for the contract. At expiry:

If the stock is at $104, it has risen 4%, but the call has no intrinsic value and expires worthless. You lose the full $100.
If the stock is at $106, the call is worth $1.00, exactly what you paid. You break even, before costs.
If the stock is at $108, the call is worth $3.00, a gain of $200 on $100 risked.

To profit, the buyer needs to be right about direction, size and timing, all within a few days. Several things make that harder:

Time decay is fastest near expiry. Each day that passes without a move takes a larger bite out of the premium.
Implied volatility can fall. After an event, the option can lose value even when the stock moves the right way.
Spreads are wide relative to price. A spread of $0.05 on a $0.50 option is 10% of its value, paid on entry and again on exit.
Losses are fast and total. An out-of-the-money option can go to zero in a few hours, so a string of small bets can drain an account quickly.

None of this means options are bad tools. Investors use them to hedge shares they own, and professionals use them in many ways. It means a beginner should understand exactly what they're paying for and how much they can lose before buying one.

In the US, brokers must give customers the Options Clearing Corporation's booklet Characteristics and Risks of Standardized Options before approving them for options trading. It's worth actually reading.

Key terms

Call / put: The right to buy (call) or sell (put) the underlying at the strike price.
Strike price: The price at which an option lets its holder buy or sell.
Premium: The price paid for an option; a buyer's maximum loss.
Expiry: The last date on which an option can be exercised.
Time decay: The loss of an option's time value as expiry approaches, fastest near the end.
Implied volatility: The future volatility implied by an option's market price.

Next lesson: Lesson 7: Crypto markets

General education, not investment advice.