Options trading doesn’t have to be complicated. The truth is, any trader can use options to diversify their portfolio, capitalize on price action, hedge positions, and generate income.
This article introduces you to options trading to give a basic understanding as you move forward in your trading education.
How do options contracts work?
There are four components to every options contract:
- The underlying asset
- The strike price
- The expiration date
- The cost (also known as the premium)
An options contract is simply an agreement between a buyer and a seller.
Buying an option gives you the right to buy or sell stock. Selling an option obligates you to buy or sell stock.
You can sell an option contract you don’t already own. This is similar to short selling stock (though you don't have to be bearish on the underlying security, as you'll learn below).
If you buy an option, you can sell it before the contract expires. If you sell an option, you can also exit your position at any time. However, you could be assigned shares of stock, which is your risk as the seller. (More on assignment later).
The Handbook has a comprehensive introduction to options basics.
Let’s take a closer look at an options contract.
Every option contract is linked to an underlying asset. Options are a derivative financial instrument. Derivatives get their value from something else. Options derive their value from the contract’s underlying asset.
For example, an Amazon option's value is based on the the price movement of AMZN stock.
One option contract is equivalent to 100 shares of stock. This is known as the contract multiplier.
Every option has a strike price. An option’s strike price is the price you can buy or sell the underlying security.
For example, a call option with a $100 strike gives the buyer the right (but no obligation) to buy 100 shares (per contract) of the underlying security for $100 per share. The option seller is required to sell the 100 shares at $100. (More on call options later).
All options have an expiration date. The expiration date is the final day the contract can be traded or exercised.
You do not have to hold an option until expiration. You can exit an option position before the expiration date to lock in a profit or minimize a loss.
Several factors influence an option’s price. Every option has extrinsic and intrinsic value.
What is extrinsic and intrinsic value?
Extrinsic value comes from factors such as time and volatility. The more time until expiration or the higher the implied volatility, the more expensive the option.
Learn more about time decay and implied volatility.
Intrinsic value (also known as an option’s moneyness) is determined by the underlying’s price relative to the option’s strike price.
A call option’s intrinsic value is the amount the underlying’s current price is above the option’s strike price. A put option’s intrinsic value is the amount the underlying’s current price is below the option’s strike price.
For example, if a stock is trading at $105 per share, a call option with a $100 strike price would be in-the-money and have an intrinsic value of $5.
If the underlying security’s price is below the call option’s strike price, the call option is out-of-the-money, and the intrinsic value is $0.
In-the-money options are more expensive than out-of-the-money options because they have intrinsic value.
Exercise & assignment
Exercise and assignment are two sides of the same transaction. An option buyer has the right to exercise an options contract. An options seller is obligated to accept assignment from an exercised contract.
Option holders (the buyer) can exercise an option any time before expiration. However, a buyer would only exercise their option if it was in their best interest.
For example, if you own a call option with a $100 strike price and the stock is currently trading at $95, it does not make sense to exercise the option.
If the stock price is $105 and near expiration, you could exercise the option and own shares at $100.
Option writers (the seller) cannot refuse assignment. Assignment is random and can happen anytime before expiration, though it typically happens late in the expiration cycle.
Call and put options
All options are divided into two types: calls and puts. A call option’s value increases if the stock’s price goes up. A put option’s value increases if the stock’s price goes down.
Buying a call option gives you the right to buy shares of a stock at the option’s strike price.
Selling a call option obligates you to sell shares of a stock at the option’s strike price.
Buying a call option means you're bullish on the stock because a call option’s value increases when a stock’s price increases. Selling a call option is bearish because you benefit from the stock's price declining.
Buying a put option gives you the right to sell shares of a stock at the option’s strike price.
Selling a put option obligates you to buy shares of a stock at the option’s strike price.
Buying a put option means you're bearish on the stock because a put option’s value increases when a stock’s price decreases. Selling a put option is bullish because you capitalize on the stock's price rising.
Many investors buy options because they have defined risk and are a cost-effective alternative to buying stock.
For example, buying a call option is a less expensive alternative to owning 100 shares of stock, with the added bonus of knowing your max loss when you enter the trade.
Combining options with a stock position is a popular first step for many new options traders. Covered calls enable you to potentially generate income while owning shares of stock.
Check out our complete Options Strategy Guide to learn more about single-leg and multi-leg strategies.
Options trading certainly can’t be explained in a single blog. But you now have the building blocks needed to take the next steps.
Ready to learn more about options trading? We have you covered!
Option Alpha’s University has free courses with dozens of videos to guide you from a beginner to an advanced options trader.