What are Options

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Options are a versatile class of financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or on a specified date. They are widely used for hedging, speculation, income generation, and risk management.

This article explains what options are, how they work, the main types of options, the mechanics of pricing and exercise, common strategies, risks, and practical examples to help you understand and use options responsibly.

Quick summary:

• A call option gives the right to buy the underlying asset.
• A put option gives the right to sell the underlying asset.
• Options have an expiry date and a strike price.
• Buying options limits your downside to the premium paid; selling options may expose you to unlimited or large losses.

What is an option? (basic definition)

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An option is a contract between two parties:

• The buyer (holder): pays a premium to obtain the right described in the contract.
• The seller (writer): receives the premium and takes on the obligation to fulfill the contract if the buyer exercises the option.

The contract references an underlying asset (stock, ETF, index, commodity, currency, etc.), a strike price (the price at which the asset can be bought or sold), and an expiry date (the last date the option can be exercised).

Options are derivatives because their value derives from the price and behavior of the underlying asset.

Calls vs Puts

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• Call option: gives the holder the right to buy the underlying asset at the strike price. Buyers of calls profit if the underlying asset’s price rises above the strike price plus the premium paid.
• Put option: gives the holder the right to sell the underlying asset at the strike price. Buyers of puts profit if the underlying asset’s price falls below the strike price minus the premium paid.

Simple mental model:

• Buy a call when you expect the underlying to go up.
• Buy a put when you expect the underlying to go down.

Key terms and mechanics

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• Underlying: the asset the option references (e.g., stock, index, ETF).
• Strike price (or exercise price): the price at which the option holder can buy (call) or sell (put) the underlying.
• Expiration date: the last day the option contract is valid. After expiration, the option ceases to exist.
• Premium: the price paid by the buyer to the seller for the option contract.
• In the money (ITM): an option with intrinsic value (e.g., a call whose strike is below the current underlying price).
• Out of the money (OTM): an option without intrinsic value (e.g., a put whose strike is below the current underlying price).
• At the money (ATM): when the strike price is approximately equal to the current underlying price.
• Intrinsic value: the amount by which an option is ITM (zero if OTM).
• Time value (extrinsic value): the portion of the premium attributable to the remaining time until expiration, volatility, and other factors.

Mechanics of exercise and settlement:

• Physical settlement: exercising a call results in buying the actual shares; exercising a put results in selling the shares.
• Cash settlement: some options (especially index options) settle in cash based on the difference between the underlying price and strike.

Contract size and standardization:

• Equity options in the U.S. are typically standardized contracts representing 100 shares of the underlying.
• Strike intervals, expiration cycles, and contract sizes are defined by exchanges.

Option pricing fundamentals

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Option prices (premiums) are influenced by several factors:

• Underlying price: moves in the underlying directly affect option value.
• Strike price: deeper ITM options have more intrinsic value.
• Time to expiration: more time increases time value.
• Volatility: higher expected future volatility increases option premiums.
• Interest rates and dividends: have smaller, but measurable effects.

Two main components of an option’s price:

• Intrinsic value = max(0, underlying - strike) for calls (reverse for puts).
• Time (extrinsic) value = premium - intrinsic value.

Mathematical models (e.g., Black-Scholes, binomial trees) are used to estimate fair option prices. However, market prices often reflect supply/demand and implied volatility rather than purely theoretical values.

American vs European options

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• American-style options: can be exercised any time up to and including expiration (most equity options are American).
• European-style options: can only be exercised at expiration (many index and OTC options are European).

American options add complexity (early exercise decisions), but for many holders early exercise is suboptimal except for specific cases (e.g., capturing dividends with deep ITM calls).

Basic option strategies

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Options can be combined into strategies that change the payoff profile. Here are common building blocks:

• Long call: buy a call (bullish, limited downside = premium)
• Long put: buy a put (bearish, limited downside = premium)
• Covered call: own 100 shares and sell (write) a call against them (income generation, limited upside)
• Protective put: own the underlying and buy a put as insurance (limits downside)
• Cash-secured put: sell a put and hold enough cash to buy the underlying if assigned (income, buying at discount)
• Spreads: combine options at different strikes and/or expirations (vertical, horizontal/calendar, diagonal)
• Straddle/strangle: buy (or sell) both a call and a put at same (or different) strikes to bet on volatility

Each strategy adjusts risk/reward, defined risk vs undefined risk, and capital requirements.

Use cases: Hedging, income, and leverage

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• Hedging: Options can protect portfolios. Example: buy puts to limit loss on a long equity position.
• Income: Selling covered calls or cash-secured puts generates premium income but caps upside or obligates purchase.
• Leverage and speculation: Buying options gives exposure to large percentage moves for a small premium. Leverage increases both potential gains and the risk of total loss (premium).

Risks and considerations

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• Time decay (theta): Options lose time value as expiration approaches. Long option holders lose value from time decay.
• Volatility risk (vega): Changes in implied volatility can significantly affect premiums.
• Assignment risk (for sellers): Sellers of options can be assigned at any time (especially American-style), requiring them to deliver or buy the underlying.
• Liquidity and bid-ask spreads: Some strikes or expirations are illiquid; wide spreads increase trading costs.
• Margin and capital requirements: Selling options may require margin and can expose you to large losses.
• Complexity and behavior: Complex multi-leg strategies have non-linear payoffs and require careful analysis.

A simple worked example

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Imagine stock XYZ trading at $50. You buy a 1-month call with a strike of $55 for a premium of $1.50.

• Break-even at expiration = strike + premium = $56.50.
• If XYZ finishes at $60, the call is worth $5 intrinsic (60 - 55), profit = $5 - $1.50 = $3.50 per share (x100 = $350).
• If XYZ finishes at $53, the call expires worthless; loss = premium = $1.50 per share (x100 = $150).

If instead you sold the same call (covered call with 100 shares owned):

• You keep the $150 premium as income upfront.
• If XYZ rallies above $55, your shares may be called away and you forgo upside above $55.
• If XYZ falls, the premium cushions losses slightly.

Practical tips for beginners

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• Start with covered calls and protective puts to learn mechanics with limited risk.
• Trade liquid, well-known underlyings (large-cap stocks, popular ETFs).
• Paper trade or use a small account to test strategies before committing significant capital.
• Monitor implied volatility: buying options before a volatility spike can be expensive; selling premium when IV is high can be attractive.
• Keep an eye on expiration dates and short option positions as theta accelerates near expiry.

Next steps & learning resources

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• Read: “Options as a Strategic Investment” by Lawrence McMillan (comprehensive reference).
• Practice: Use paper trading or virtual platforms provided by brokers to practice multi-leg positions.
• Study: Greeks (delta, gamma, theta, vega, rho) - understanding them is essential for risk management. I’ve got separate articles on this topic.
• Explore: Common strategies in more depth - vertical spreads, iron condors, calendars.

Visual Payoff Profiles (interactive)

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To make the concepts concrete, below is an interactive payoff diagram. Use the dropdown to select a strategy (Long Call, Long Put, Covered Call, or Protective Put), then adjust the Strike, Premium, or Spot and click Update to see how payoffs move.