What Are Options? The Right to Buy or Sell at a Set Price
An option gives you the right, but not the obligation, to buy or sell something at a set price before a set date. Options are used for speculation, hedging, and income generation.
An option is a contract that gives you the right, but not the obligation, to buy or sell an asset at a predetermined price on or before a predetermined date.
Unlike a stock (where you own the company), an option is a derivative: its value is derived from something else (a stock, an index, a commodity).
Call Options: The Right to Buy
A call option gives you the right to buy an asset at a specific price (the strike price) on or before the expiration date.
Example: You buy a call option on Apple stock with:
- Strike price: $150
- Expiration: in 30 days
- You pay a premium (cost) of $3 per share
Your profit/loss scenarios:
| Stock price at expiration | What you do | Profit/Loss |
|---|---|---|
| $140 (below $150) | Let option expire | -$3 (lost premium) |
| $150 (at strike) | Indifferent | -$3 |
| $153 (above breakeven) | Exercise, buy at $150 | $0 (breakeven) |
| $170 | Exercise, buy at $150, sell at $170 | +3 = +$14 |
You only exercise when it’s profitable. Maximum loss is the premium you paid.
Put Options: The Right to Sell
A put option gives you the right to sell an asset at a specific price.
Example: You buy a put option on Tesla stock with:
- Strike price: $200
- Expiration: in 30 days
- Premium: $5 per share
Profit/loss scenarios:
| Stock price at expiration | What you do | Profit/Loss |
|---|---|---|
| $220 (above strike) | Let option expire | -$5 |
| $200 (at strike) | Indifferent | -$5 |
| $195 | Exercise, sell at $200, buy at $195 | +5 = $0 (breakeven) |
| $170 | Exercise, sell at $200, buy at $170 | +5 = +$25 |
Puts are like insurance: you pay a premium to protect against a price decline.
American vs. European Options
American options: Can be exercised at any time before expiration. Most US-listed options are American.
European options: Can only be exercised at expiration, not before. Index options are often European.
Intrinsic Value and Time Value
An option’s price (premium) has two components:
Intrinsic value: The profit you’d make if you exercised now.
Time value: The premium you pay above intrinsic value, reflecting the chance the stock could move further in your favor before expiration.
Example: Stock at $160, call strike $150, premium $14.
- Intrinsic value = 150 = $10
- Time value = 10 = $4
As expiration approaches, time value shrinks, this is called time decay.
What Determines an Option’s Price?
The Black-Scholes model (and its variants) gives the key drivers of option prices:
1. Stock price: Higher stock price → higher call value, lower put value.
2. Strike price: Higher strike → lower call value, higher put value.
3. Time to expiration: More time → higher premium (more chance for movement).
4. Volatility: Higher stock volatility → higher option premium (more chance of big moves).
5. Risk-free interest rate: Higher rates → slightly higher call values, slightly lower put values.
The Greeks: Measuring Option Sensitivity
Options traders use “Greeks” to measure risk:
Delta (Δ): How much the option price changes for a $1 move in the stock.
- Calls: Delta 0 to +1. At-the-money calls ~0.5.
- Puts: Delta 0 to -1. At-the-money puts ~-0.5.
Gamma (Γ): How fast delta changes. Highest for at-the-money options near expiration.
Theta (Θ): Time decay, how much value the option loses per day as expiration approaches.
Vega (ν): How much the option price changes for a 1% change in implied volatility.
Rho (ρ): How much the option price changes for a 1% change in interest rates.
Covered Calls and Cash-Secured Puts: Income Strategies
Covered call: You own 100 shares of a stock and sell a call option against them. If the stock stays below the strike, you keep the premium. If it rises above the strike, your shares get “called away” (sold) at the strike price.
Cash-secured put: You sell a put option and hold enough cash to buy the stock if assigned. You collect premium and wait. If the stock falls below strike, you may end up buying the stock at a price you already agreed to.
Both strategies generate income from selling options against stock you own or cash you’re willing to deploy.
Options vs. Stocks: Key Differences
| Stocks | Options | |
|---|---|---|
| Ownership | Yes | No (right only) |
| Loss potential | 100% of investment | 100% of premium |
| Leverage | None | Yes (control more shares for less) |
| Time decay | No | Yes (theta erodes value) |
| Voting rights | Yes | No |
Key Takeaways
- Call = right to buy; Put = right to sell. Neither obligates exercise.
- Maximum loss on buying options = the premium paid
- Options have intrinsic value + time value; time value decays as expiration approaches
- Greeks (delta, gamma, theta, vega) measure option price sensitivity
- Options provide leverage but also time decay risk
- Covered calls and cash-secured puts generate income from selling options
References
- Hull, Options, Futures, and Other Derivatives. Pearson, 2018. ISBN: 978-0-13-463149-3.
- Natenberg, Option Volatility and Pricing. McGraw-Hill, 1994. ISBN: 978-0-07-181878-0.