What are Options

Ever heard people talking about “options” and you had no clue what it means? But here’s the secret. Options aren’t as complicated as they sound and not necessarily as risky as you think.

Think of an option as a “maybe” for your stocks. It’s a contract that gives you the right, but not the obligation, to buy or sell a stock at a set price by a certain date. It’s like putting a deposit down on a house. You’ve locked in the price, but you can still walk away.

This article is your guide to understanding options without getting confused. I’ll try to cover what they are, how they work, and a few simple ways people use them to either protect their investments or try to make a profit.

So, what’s an option?

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At its core, an option is just a contract between two people:

• The buyer pays a small fee (called a premium) for the right to buy or sell a stock later.
• The seller gets that premium, but in exchange, they have to buy or sell the stock if the buyer decides to go through with it.

Every option contract is tied to a few key things: an underlying asset (like shares of Nvidia), a strike price (the price you’ve agreed on), and an expiration date (the day the contract ends).

Because their value is derived from the stock they’re linked to, options are called derivatives.

Calls vs. Puts: The Two Flavors of Options

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This is the most important part to get right. There are only two types of options:

• Call Option: Gives you the right to buy a stock at the strike price. You’d buy a call if you think the stock’s price is going to rise. If you’re right, you can buy the stock at a discount and sell it for a profit.
• Put Option: Gives you the right to sell a stock at the strike price. You’d buy a put if you think the stock’s price is going to fall. If it does, you can sell the stock for more than it’s worth.

Here’s a simple way to remember it:

• Call up: You want the stock to go up.
• Put down: You want the stock to go down.

Key Terms

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• Underlying: The stock or ETF the option is for (e.g., AMD, SPY).
• Strike Price: The locked-in price to buy or sell.
• Expiration Date: The “use by” date. The option is worthless after this.
• Premium: The cost of the option contract.
• In the Money (ITM): The option is currently profitable (not counting the premium). A call is ITM if the stock price is above the strike. A put is ITM if the stock price is below the strike.
• Out of the Money (OTM): The option is currently not profitable.
• At the Money (ATM): The strike price is pretty much the same as the stock’s current price.
• Intrinsic Value: The actual value of an ITM option.
• Time Value: The “hope” value. It’s the extra amount people will pay for the chance the option will become profitable before it expires.

How it works when you “exercise” an option:

• Physical settlement: You actually buy or sell the shares.
• Cash settlement: More common for index options. You just get paid the difference in cash.

Good to know: In the U.S., one stock option contract almost always represents 100 shares of the stock.

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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Next steps & learning resources

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• Read books about trading with Options
• Practice: Use paper trading or virtual platforms provided by brokers to practice.
• 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. Focus on cash secured puts and covered calls.

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.