Introduction to Options

Options are derivative securities, meaning their value is tied to an underlying asset like a stock. They give you the option, or right—but not the obligation—to buy or sell a security at a fixed price within a certain time frame. Options allow investors to profit from price movements, manage risk, or hedge existing positions. While they can generate great returns, they can also be extremely risky, as many users of r/WallStreetBets have found out the hard way.

An options contract involves two parties: the person writing (selling) the contract, and the person buying it. The seller is obligated to buy or sell the security at a specific price if the buyer chooses to exercise their right. The buyer, however, has the right, but not the obligation, to complete the transaction.

This can be confusing at first, so let’s look at a simplified example. Suppose $AAPL is trading at $100 a share, and you believe its price will rise over the next few months. You buy an option that gives you the right to purchase $AAPL at a fixed price of $105, for which you pay a $2 per share premium. If you want to control 100 shares, it will cost you $200.

If $AAPL rises to $110, you can exercise your right to buy at $105, then sell at the market price of $110, making a profit. But if $AAPL falls to $95, there’s no point in exercising your option—you could buy the shares cheaper in the market. The option expires, and you’re out the $2 per share premium.

However, in the losing scenario, you still risked less than if you’d bought and held the stock outright. While a drop from $100 to $95 would result in a $5 loss per share for a stockholder, your loss is limited to the $2 premium you paid per share for the option.

Types of Options

There are two types of options. Calls and puts.

Calls

A call option gives the buyer of the contract the right to purchase an asset at a predetermined price, known as the strike price at any point before the contract's expiration. They're primarily purchased by investors who believe that the price of the security will rise, allowing them to buy the security at the lower strike price and turn around and sell the security at the higher market price.

When you purchase a call option, you're locking in the right to purchase the security at a specific price, regardless of how high the price rises (or lowers). It's only advantageous to the option holder to exercise the option if the market price rises above the strike price; you wouldn't buy a security for a premium if you could get it on the market for a lower price. If the market price remains below the strike price, you'd let the option expire and you'd only lose the premium that you paid for the option.

Example

Imagine $TSLA is trading at $300 a share, and you think it will go up in the next three months. You buy a call option with a strike price of $320, expiring in three months, and pay a $10 premium for each share. If $TSLA rises to $350 during that time, you can exercise your option to buy at $320, and immediately sell at $350, pocketing the difference. Your profit would be the gain from selling at $350 minus the premium and strike price costs.

• Strike Price: $320
• Market Price: $350
• Premium Paid: $10 per share
• Profit: ($350 - $320) - $10 = $20 per share
  

If $TSLA doesn’t reach $320, you wouldn’t exercise the option, and your only loss is the $10 premium.

There's two other possibilities with call options. First, the market price doesn't rise above the strike price, in which case you're out the full cost of the premium paid (in this case, $10 per share). Second, the market price may rise above the strike price, but not enough to cover the premium. We'll cover that scenario in the following example.

You bought a call option with a strike price of $320 and paid a $10 premium per share. Now, let’s see what happens when $TSLA’s market price rises to $325.

• Strike Price: $320
• Market Price: $325
• Premium Paid: $10 per share
  

When the market price reaches $325, you can exercise your option to buy $TSLA at the strike price of $320. Since the market price is now $325, you can immediately sell the stock at $325, giving you a profit of $5 per share (the difference between $325 and $320).

However, you need to account for the premium you paid to purchase the option. You paid $10 per share as a premium, so your total outcome would be:

• Profit: ($325 - $320) = $5 per share
• Net Loss: $5 (Profit) - $10 (Premium) = -$5 per share loss
  

So, even though $TSLA increased in price, your gain from exercising the option ($5 per share) doesn’t fully cover the $10 premium you initially paid. As a result, you would still end up with a net loss of $5 per share. This is better than a loss of $10 a share, so you'd definitely want to exercise your call option.

Puts

A put is the opposite of a call; it gives the buyer of the contract the right to sell a security at a predetermined strike price before the contract's expiration. Investors purchase put options when they believe that the price of a security will fall, allowing them to sell the asset at a higher price than what the market is buying them at.

You'd exercise your put option when the market price is lower than the strike price. You'd then sell the security for the strike price to the originator of the contract. There are still premiums involved, so that needs to figure into the calculation as well.

Let’s say $AAPL is trading at $100 a share, and you think the price will drop. You buy a put option with a strike price of $90, expiring in two months, and pay a $5 premium for each share. If $AAPL drops to $80 during that time, you can exercise your option to sell at $90, even though the market price is lower. This scenario shows a profit of $5 per share after accounting for the $5 per share premium.

• Strike Price: $90
• Market Price: $80
• Premium Paid: $5 per share
• Profit: ($90 - $80) - $5 = $5 per share
  

If $AAPL stays above $90, you wouldn’t exercise the option, and your only loss would be the $5 premium.

The same possibilities we discussed with call options are present here, just in reverse. If the market price remains higher than the strike price, you'd let your option expire worthless and your loss is limited to the premium per share. The market price may also only drop slightly, not fully covering your premium. In this case, you'd exercise your option to reduce your losses. As an example, let's consider if $AAPL drops to $85 instead of $80.

• Strike Price: $90
• Market Price: $85
• Premium Paid: $5 per share
  

Since the market price is now $85, you have the right to sell $AAPL at $90 through your put option. The difference between the strike price and the current market price gives you a profit of $5 per share ($90 - $85).

Now, let’s account for the premium you paid:

• Profit: ($90 - $85) = $5 per share
• Net Profit/Loss: $5 (Profit) - $5 (Premium) = $0 per share (break-even)
  

Would You Exercise the Option?

Yes, you would exercise the option, because the market price is below the strike price, allowing you to sell $AAPL at the higher $90 price rather than at the market price of $85. However, after factoring in the premium you paid, you would only break even, meaning you neither gain nor lose money.

Summary

The table below summarizes the key concepts when considering each option type. Investors buy calls when they believe that a security will appreciate in value. Conversely, investors purchase puts when they believe the asset will depreciate. These aren't the only reasons, however, as we'll touch on in a later section.

As mentioned earlier, there are always two sides to an option: the party selling (writing) the option, and the party purchasing the option. In the next section, we'll cover long and short positions as they relate to the options.