Options

Quick definition An option is a derivative contract granting the right, but not the obligation, to buy or sell a security at a fixed price on or before a specified date. Calls grant the right to buy; puts grant the right to sell. What it is Options come in two types. A call option gives the holder the right to buy at a strike price. A put option gives the holder the right to sell at a strike price. The holder pays a premium (the option price) upfront to acquire these rights. At expiration, the holder exercises the option if profitable or lets it expire worthless. Example: a call option on Apple with a 150 dollar strike and one month to expiration. If you pay 2 dollars for this call and Apple trades at 152 dollars at expiration, you exercise the call, buying at 150 and profiting 2 dollars per share (minus the 2 dollar premium paid, so break-even). If Apple trades at 148 dollars, you let the option expire worthless, losing the 2 dollar premium. Why it matters Options are fundamental to institutional trading. Portfolio managers use puts to hedge downside risk. Traders use calls to bet on upside moves with limited capital. Market makers in options extract value by quoting bid-ask spreads. Options pricing depends on five variables: underlying price, strike price, time to expiration, volatility, and interest rates. Small changes in volatility (implied volatility) can move option prices significantly, creating trading opportunities. American versus European options American options can be exercised any time before expiration. European options can only be exercised at expiration. American options are worth more because they offer more flexibility. Most exchange-traded options (on stocks, indices) are American style. Practical example You expect a stock to fall. You buy a put option with a 100 dollar strike. You pay 3 dollars for the option. If the stock falls to 95 dollars before expiration, the put is worth at least 5 dollars (intrinsic value: right to sell at 100 when stock is 95). Your profit is 2 dollars per share. If the stock rises to 105 dollars, the put expires worthless. Your loss is the 3 dollar premium. Moneyness Moneyness describes whether an option is profitable to exercise now. In-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value (but may have time value). See also - Implied Volatility - Delta - Gamma - Vega - Strike Price