An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a fixed price on or before a set date. The buyer pays a price for that right, called the premium. The seller (or writer) collects the premium and takes on the obligation.
Call options
A call gives the buyer the right to buy the underlying at the strike price. Traders buy calls when they expect the price to rise. If the stock trades at 100 and you buy the 105 call, the option only has value at expiry if the stock finishes above 105.
Put options
A put gives the buyer the right to sell the underlying at the strike price. Puts gain value when the price falls, so traders use them to speculate on a decline or to protect shares they already own.
The key terms
- Strike price: the price at which the option can be exercised.
- Expiry: the last day the contract is valid.
- Premium: what the buyer pays and the seller receives.
- Lot size: the number of shares or units one contract covers.
- In the money (ITM): a call with strike below the market price, or a put with strike above it.
- Out of the money (OTM): the opposite. At expiry an OTM option is worth zero.
Buyers and sellers have very different risk
An option buyer can lose at most the premium paid. An option seller keeps the premium if the option expires worthless, but can face large losses if the market moves sharply against them. That is why brokers ask for margin from sellers.
Intrinsic value and time value
An option’s premium has two parts. Intrinsic value is how far in the money it is right now. Time value is everything else: the market’s price for the chance that the option becomes more valuable before expiry. Time value shrinks every day and reaches zero at expiry.
Once these basics are clear, the next step is to learn how option prices react to movement, time and volatility. Those sensitivities are called the Greeks.
This article is for education only and is not financial advice. Options involve risk and are not suitable for every investor.