What is an Option?
Updated
by Justin Ling
What are they?
Options are contracts that grant the buyer the right, but not the obligation, to buy or sell an underlying security at a predetermined price. If the buyer decides to use, or exercise, their option, the seller of the option has the obligation to buy or sell the underlying security at the contract’s predetermined price.
There are two types of options: calls and puts. Calls give the buyer the right, but not the obligation, to buy an underlying at the strike price. Puts give the buyer the right, but no the obligation, to sell the underlying at the strike price. Owners of calls benefit when the market price is above the strike price at or before expiration. Owners of puts benefit when the market price is below the strike price at or before expiration.
TL;DR: In other words, if you’re a buyer of options, calls are a bet that the price of the underlying will rise within the time of the contract while puts are bets that the price will drop within the time of the contract.
Why buy options?
There are many reasons to buy options. On the most basic level, the two major reasons an investor could have are to either 1) protect an existing open position or to 2) profit from a movement in price in either direction.
In any case, the advantage of buying options comes from their lower price and reduced risk relative to having a position with the underlying directly. The disadvantage of buying options comes from their limited time frame (options expire) and the inability to participate in profits from dividends (you are only entitled to a dividend if you own the underlying - not its derivative).
Protecting an existing open position
If you’re long an underlying, then buying a put with a strike at or below current price can limit your loss. For example, if you bought the underlying at 100 and a put at 80, then your maximum loss (excluding the cost of buying the contract) is 20 per share, the difference between the price you bought the underlying at and the put’s strike.
If you’re short an underlying, then buying a call with a strike at or above the current price can limit your loss. For example, if you shorted the underlying at 100 and bought a call at 120, then your maximum loss (excluding the cost of buying the contract) is 20 per share, the difference between the call’s strike price and the price you shorted the underlying.
Profit from a movement in price in either direction
Just like when you buy or short an underlying, buying an option contract can be used to profit from a price movement. As a buyer of options, you get the same upside exposure that you would get from buying or shorting the underlying directly (minus dividend payouts — but that’s accounted for in the price of the option).
The first advantage of buying an option is that is a lot cheaper than owning the underlying, so it allows you to take on a much larger position at a fraction of the upfront cost.
The second advantage of buying an option is that it limits your downside risk. Essentially, as a buyer of options, your worst case scenario is the loss of the premium. That means that your risk is much more limited than if you have an open position. Think of it this way, if you own an underlying, the price could go to zero and you’d lose whatever you paid for it. If you’re short an underlying, the price could theoretically go to positive infinity and your loss could be infinite. But if you own a call, and the price plummets, no sweat, the option will expire worthless and you’d only lose what you paid when you bought the contract. Likewise, if you own a put and the price rises exponentially, you only lose your premium.
TL;DR: You get the same upside exposure you would if you owned or shorted the underlying at a fraction of the price without the downside risk.
Best case scenarios
If you own a call, your maximum profit is the same as if you owned the underlying - theoretically limitless (positive infinity - the cost of the contract). If you own a put, your maximum profit is comparable to shorting the underlying (strike - the cost of the contract).
Worst case scenarios
The worst that can happen to an owner of options is that the market price never reaches a point where the price becomes profitable (for a call that’s strike + cost of contract, for a put that’s strike – cost of contract). If that happens, the option isn’t exercised and it expires worthless, meaning that the maximum loss is the cost of the contract.
Why sell options?
A seller of options is looking to profit from premiums. The best case scenario for a seller of options is for the option to expire worthless. If a buyer does not exercise their option, then the seller gains the premium (the price of the contract at time of purchase) without having to put up any money up front.
Essentially, the seller of options is taking on the opposite view of the buyer of the options. For instance, whereas the buyer of a call benefits from an upward movement in price, a seller of a call benefits if the price falls or remains at the strike’s level. And whereas a buyer of puts benefits from a downward movement in price, a seller of puts benefits when the price rises or stays at the strike’s level.
What could go wrong? A LOT. Whereas a buyer of options enjoys limited risk and is not obligated to exercise an option, a seller of options takes on significant risk. Think about it this way, if you sell a call and the price rises, potentially to infinity, then you could lose an infinite amount (positive infinity - the profit from the cost of the contract) and if you sell a put and the price falls, you could lose the strike price - the profit from the cost of the contract.
TL;DR: If the option expires worthless (ie the buyer does not exercise the option), you gain the option premium without putting having to put any money up front. But if it goes the other way, you could lose a lot.
Best case scenarios:
The option expires worthless. Your maximum gain is the price of the option contract, also called the option premium.
Worst case scenarios:
The worst that can happen to a seller of options is that the market reaches a price where it is profitable for the buyer to exercise the option. Maximum loss here can be infinite if you are a seller of calls and the strike price (minus the option premium) if you’re a seller of puts.
Options points system:
1. If you BUY an option contract, you will receive a point on your options trades score.
A) If the option expires, no additional points are awarded.
B) If you exercise the option, you will receive a point on your equity trades score.
2. If you SHORT (write) an option contract, you will receive a point on your options trades score.
A) If the option expires in the money (for a call: market price > strike price; for a put: market price < strike price), option will be exercised by buyer (you will automatically buy or sell at the strike price, depending on contract terms). No additional points will be awarded.
B) If the option expires out of the money (for a call: market price < strike price; for a put: market price > strike price), option will be removed from holdings. No additional points will be awarded.
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