Glossary · Funds and derivatives
Options
An option is a contract that gives its buyer the right, but not the obligation, to buy or sell something at a set price before or on a set date.
Also called: option, stock options, options trading, option contract
In plain words
You find a bike you like for $500 but are not sure yet. The shop agrees to hold that price for you for a month if you pay $20 now. If you decide to buy, you pay $500; if you find a better bike, you walk away and lose only the $20. You have bought an option.
Financial options work the same way. A call option gives the right to buy at a set price (the strike); a put option gives the right to sell at the strike. The price you pay for that right is the premium. Every option has an end date, the expiry, after which the right is gone.
The buyer can lose at most the premium. The seller (the writer) of the option keeps the premium but takes on the duty to trade if the buyer asks, and that can cost far more.
Example
A call option vs buying the shares
A share trades at $50. You think it will rise. A call option on 100 shares with a $50 strike, expiring in three months, costs $2 a share: $200.
- The share rises to $60. The call lets you buy at $50 shares worth $60: worth $10 × 100 = $1,000. Profit: $1,000 − $200 = $800, four times the money you paid.
- Had you bought 100 shares for $5,000 instead, the profit would be $1,000: 20%.
- The share falls to $48. The call expires worthless: you lose $200, all you paid. The shareholder loses $200 too, but only 4% of their $5,000.
Options turn a small premium into a big bet: the payoff is lopsided, a capped loss for the buyer and a much larger possible gain.
One level deeper
What makes an option expensive? How far the price already is beyond the strike (the intrinsic value), how much time is left, and above all how much the underlying is expected to swing. The more uncertain the future, the more a right to choose is worth. Fischer Black, Myron Scholes and Robert Merton published a formula for this in 1973, the same year the first options exchange, the Chicago Board Options Exchange, opened.
US stock options usually cover 100 shares. American-style options can be used any day up to expiry; European-style only at expiry. Most options are never exercised: they are sold back before expiry or simply expire.
Option prices hold the market’s forecast of swings. The VIX is calculated from the prices of options on the S&P 500, which is why it is called the market’s fear gauge.
What a call, a put and a share pay at expiry
Options with a $100 strike, bought for $5 a share, and one share bought at $100. Move along the line: the call buyer loses at most $5 and starts to profit above $105; the put buyer profits below $95. The shareholder gains and loses dollar for dollar.
The numbers behind the chart
| Call buyer | Put buyer | Shareholder (bought at $100) | |
|---|---|---|---|
| $70 | −$5 | $25 | −$30 |
| $75 | −$5 | $20 | −$25 |
| $80 | −$5 | $15 | −$20 |
| $85 | −$5 | $10 | −$15 |
| $90 | −$5 | $5 | −$10 |
| $95 | −$5 | $0 | −$5 |
| $100 | −$5 | −$5 | $0 |
| $105 | $0 | −$5 | $5 |
| $110 | $5 | −$5 | $10 |
| $115 | $10 | −$5 | $15 |
| $120 | $15 | −$5 | $20 |
| $125 | $20 | −$5 | $25 |
| $130 | $25 | −$5 | $30 |
Why it matters
Options let investors buy insurance: a put limits how much a fall can cost.
They let traders make big bets with little money, which is why option trading by individuals has boomed and sometimes driven wild moves in single stocks.
Their prices tell us how much risk the market expects, through measures like the VIX.
A common mistake
Myth: Selling options is a safe way to earn steady income.
In fact: Sellers collect small premiums most of the time and then, occasionally, take a huge loss. Someone who sells calls without owning the shares faces a loss with no upper limit if the price shoots up.
Questions people ask
What is the difference between a call and a put?
A call is the right to buy at the strike price, so it gains when the price rises. A put is the right to sell at the strike, so it gains when the price falls.
How do options make money?
The buyer profits if, at expiry, the option is worth more than the premium paid: for a call, if the price ends above the strike plus the premium. The seller profits if it is worth less, keeping all or part of the premium.
Why do most options expire worthless?
Many are bought out of the money, with strikes the price never reaches, and some are bought as insurance that is not needed. It does not mean sellers always win: their rare losses can be large.
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About the numbers
- This page explains a term. It is not investment advice.