Options are a powerful and unique investment tool that can offer new perspectives for a portfolio. Options are used for many different reasons, but most commonly to reduce required capital, magnify returns, and provide protection on underlying positions. There are risks associated with options, so it’s imperative to have a complete understanding of them before engaging in options use.

At their core, options are an agreement between two people to buy or sell an underlying stock at a specified time in the future for a specified price. Options are a form of “derivative” investment because options derive their value from the underlying stock that they assign rights to.

Starting with the terminology

Call – the first type of option. Buying calls gives you the right to purchase the stock at the predetermined price. This action is associated with a bullish outlook. Selling calls may obligate you to sell the stock at the predetermined price if someone calls the stock from you. This action is associated with a neutral or bearish outlook.

Put – the second type of option. Buying puts gives you the right to sell a stock at a predetermined price. This action is associated with a bearish outlook. Selling puts may obligate you to purchase the stock at a predetermined price if someone puts the stock to you. This action is associated with a neutral or bullish outlook.

Contract – the unit of an option, this controls 100 shares of the underlying stock.

Premium – the cost of the option. You pay this amount when buying, or receive this amount when selling. The listed price is ‘per share’, which means it is multiplied by 100 when you make the purchase/sale of the option, because it controls 100 shares. For example, 1 options contract for stock XYZ is listed at $1.23, purchasing this option will cost $123.00 (plus any fees).

Exercise – the term for “using” the option to convert your contracts into actual shares of stock. Only purchasers get to choose to exercise their options. This can be done instead of selling your contracts to close your position.

Expiration – the deadline when the option is no longer valid and the agreement is terminated. Options are usually exercised on the last day before expiration.

Strike price – the predetermined price at which the underlying stock will be bought or sold upon exercise of the option.

In the money (ITM) – when the stock price is above the strike for a call, or below the strike for a put. This means there is intrinsic value in the option already.

At the money (ATM) – when the stock price is at (or very close to) the strike price. 

Out of the money (OTM) – when the stock price is below the strike for a call, or above the strike for a put. This means the stock price has to move past the strike price for the option to have value at expiration. There is only time value on these options until they are in the money.

Buy the right, Sell the obligation

Options can be bought or sold to establish a position, however there is a fundamental difference based on which side you are on. Purchasing an option gives you the right to exercise it if the position is favorable, but doesn’t force you to do anything. Selling an option means you are obligated to fulfill the option if it is exercised by the buyer. You can always close out of your position any time by selling/buying the option back (as long as there is trading volume), rather than exercising it.

How it’s priced

Options themselves don’t have value, but the stock that they are tied to does, so the pricing gets somewhat complex. Options can be thought of as a bet with a time limit. Depending on what you buy or sell, you are betting against someone else that the underlying stock will go up or down past a certain value by a certain date. Since an expiration date further out in the future gives the option a longer timeframe to work out positively, the seller has to be compensated with a higher premium.

Premium = Intrinsic Value + Time Value

For a call: Intrinsic Value = Stock Price – Strike Price

For a put: Intrinsic Value = Strike Price – Stock Price

Time Value = Premium – Intrinsic Value

Buying an option gives you the right, but not the obligation, to exercise, which means the minimum premium is zero dollars when determining the cost. This is because the purchaser can simply let the option expire worthless if it moves against them, losing only premium paid for the purchase but nothing more. Selling an option, however, can result in larger losses depending on the type of option. This is because the seller takes on the obligation to fulfill the option when exercised, they do not get a choice.