What Are Options and How Do They Work?

Beyond basic financial instruments such as stocks, bonds and mutual funds are a class of investments called derivatives. Derivatives are investments whose price is determined by or derived from the price of an underlying investment, such as a stock or bond. One popular type of derivative that many investors buy and sell are called options. An option gives its holder the option, but not the obligation, to buy or sell the underlying investment (such as a stock) for a predetermined price by a set date. An option that gives its holder the right to buy is known as a call option, whereas an option that gives its holder the right to sell is known as a put option.

Option Basics

There are a few different prices that you’ll see listed if you buy an option: the premium, exercise or strike price and expiration date. The premium is the price that you must pay to acquire the option itself and is on a per share basis. When an investor decides to buy or sell the underlying investment, this is called exercising the option. The exercise price is the price the option holder will pay or receive if they decide to buy or sell the underlying investment.

The expiration date is simply that: if you do not exercise the option by its expiration date, you can no longer do so and the option becomes worthless. Typically, when an investor buys an options contract on stock, it is for 100 shares of the underlying stock. For the sake of clarity, all examples in this guide assume that an option is for one share of the underlying stock.

For example, let’s say that you buy a call option to purchase Facebook stock. The exercise price for the option is $55, the premium is $5 and the expiration date is one month from now. This means that you pay the option seller $5 to acquire the option. You do not pay the $55 unless you exercise the option. If you decide to not exercise the option and it expires, then you will have only paid the option seller $5. If you do decide to exercise the option, then you will have paid $60 ($5 + $55) total.

Other terms that you will frequently hear when discussing options are in the money, out of the money and at the money. Options are said to be in the money when they have a positive payoff for the holder, meaning that the value of the option is greater than $0, and out of the money when they have a negative payoff. When an option produces a $0 payoff, it is said to be at the money. Being in the money does not necessarily mean an option is profitable, but it means that an option may be worth exercising.

Two other terms you’ll hear when discussing options are long and short. When you buy an option, you are said to be long in that option, and when you sell an option, you are said to be short in that option. A long put or call then means that a trader has purchased a put or call option, respectively. A short put or call means that an investor has written or sold a put option or call option.

Options also come in two varieties: American and European options. The only difference between the two is that American options allow the option holder exercise the option on or before the expiration date, whereas European options only allow the holder to exercise the option on the expiration date. Most options traded within the United States are American options, but occasionally buyers may see the European style.

Call Options

As mentioned above, a call option gives its holder the right to buy a financial asset at a predetermined price by a predetermined date. Investors can both buy and sell, also called “writing”, an option.

Buying a Call Option

Let’s say that you decide to buy a call option for Facebook stock again, but this time the exercise price is $60, the premium is $10 and the expiration date is one month away. A week after buying the option, Facebook stock goes up to $75. You decide to exercise the option, which is in the money, because you can now buy Facebook stock cheaper than market value ($60 vs. $75). At this point, you’ve captured a payoff of $15 due to the price difference, because you can buy the stock at $60 per share using the option and then sell it for $75 in the market. If you subtract the premium you paid initially ($10) from this payoff, then your total profit is $5.

Profit for Call Option Buyer

What if Facebook stock declines in value? Instead of Facebook rising to $75 per share, let's say it drops to $50 per share. You decide not to exercise the option, which is out of the money, because it wouldn’t make sense to overpay for a stock ($60 vs. $50). In this event, your net outlay is -$10, which is the premium you paid to acquire the option. In the graph above, you can see that once the stock price rises above $70, which is the exercise price plus the premium you paid, you begin accumulating a profit.

Writing a Call Option

Instead of buying a call option, let’s say you decide to write a call option. This time, you decide to sell a call option for Microsoft stock, with an exercise price of $60, a premium of $10 and an expiration date one month from now. On the expiration date, Microsoft stock has declined to $45 per share. Your buyer will not exercise the option, because the option is out of the money and they do not want to overpay for the stock ($60 vs. $45). Since your buyer does not exercise the option, you pocket a profit of $10 from the premium you charged. 

Profit for Call Option Writer

If the Microsoft stock goes up to $80 per share, then your buyer will exercise the option to buy the stock because it is now in the money. In this scenario, you must sell the stock for $60 to the buyer, which is a loss of $20. Your total profit would be -$10, since you lost $20 on the stock price, but gained $10 from the premium you charged. In the graph above, we can see that the call option writer turns a profit when the stock price is below the exercise price plus the premium charged ($70 in this case). However, if the stock price rises above the exercise price plus the premium, then the call option writer will suffer a loss.

Put Options

A put option gives its holder the right, or option, to sell a financial asset at a price and date specified in advance. Like a call option, an investor can either buy or write a put option.

Buying a Put Option

In this example, you are buying a put option for IBM stock with an exercise price of $45, a premium of $15 and an expiration date one month away. IBM stock drops to $25 a share the following week. You decide to exercise your option, because you can sell the stock over market value ($45 vs. $25). The difference you captured between the market value of the stock and your exercise price is $20, because you can sell the stock you have, which is worth $25 in the market, to the option writer for $45. Since you paid $15 for the option itself, your total profit would be $20 minus $15, or $5.

Profit for Put Option Buyer

If the price of the stock increased instead, then it wouldn’t make sense to exercise the option. For instance, if the stock price increased to $55, then you wouldn’t want to sell the stock for $45. Given that you paid a premium of $15 to acquire the option, you would suffer a loss of $15.

Writing a Put Option

Let’s say you decide to write a put option for IBM stock, with a strike price of $45, a premium of $15, and an expiration date one month away. If the price of IBM stock increases to $50, you will generate a profit on the put option. The buyer will not exercise the option to sell, because the strike price is under market value ($45 vs. $50) and so the option is out of the money. However, you, the seller, will keep the $15 premium you charged. Your profit on the option is therefore equal to the premium you charged the buyer.

Profit for Put Option Writer

If the price of IBM stock declines, then the buyer will likely exercise his or her right to the put option, because she can sell the stock for more than it’s currently worth. Let’s say the stock price decreases to $30 per share, which is $15 below the exercise price. In this case, your total profit would be $0, which is the $15 you lost on the stock plus the $15 premium you charged. If the stock price fell even further, you would have a loss as the premium would not be enough to offset the difference between the stock price and the exercise price.

How to Buy Options

When an investor decides to purchase an option, she will see many different options contracts on the same stock. For example, an investor decides to purchase an option on IBM stock, which is currently trading at $100 per share. She may see a number of different calls and puts available on IBM stock with different premiums, as seen in the table below. This is a simplified version of how options contracts would appear normally.

TypeStrike Price
$85.00$90.00$95.00$100.00$105.00$110.00
Call Premium $16.00 $11.00 $5.50 $2.00 $1.00 $0.50
Put Premium $0.50 $1.00 $2.00 $5.00 $10.00 $15.00

In the table above, we can see that there are three in the money call options, one at the money call option and two out of the money call options. The three call options that are in the money are $85, $90 and $95. Even though all of these options are in the money, none of them are yet profitable because the premium is equal to or greater than the difference in the stock price and the strike price. The $85 call option is $15 below the stock price of $100, but its premium is $16. This means that exercising the option would result in a loss of $1.

The other in the money call options, $90 and $95, are likewise not profitable at the current stock price. The at the money call option has an exercise price of $100, which is equal to the current stock price of $100. The two out of the money call options, $105 and $110, are also not profitable for the buyer to exercise, because they have strike prices higher than the current stock price.

In our examples above, we looked at the potential profit in different scenarios for buying and writing both call and put options. The profit of an option, excluding any broker's fees, can be calculated using the following formula:

  • Call options: Profit = Price of Underlying Asset – Exercise Price – Option Premium
  • Put options: Profit = Exercise Price – Price of Underlying Asset – Option Premium 

Let’s say we have an in the money call option on Amazon stock, which is currently trading at $45 per share, with a strike price of $30 and a premium of $10. Our profit would be $5 ($45 - $30 - $10) if we exercised the option. If we had an out of the money put option on Amazon stock, trading at the same $45 per share, with a strike price of $30 and a premium of $2, then our profit (or loss in this case) would be -$17 ($30 - $45 - $2) if we exercised the option. These examples do not include fees charged by brokers. To calculate the profit of an option including broker's fees, simply use the formulas above and subtract any additional broker's fees you paid to buy or write the option and any you will pay if the option is exercised.

To pick an option that has the potential to turn a profit, an investor needs to assess the value of an option according to her belief of whether the price of the underlying asset will go up or down. This means understanding how to calculate the profit of an option and also understanding how time until the expiration date affects the value of an option.

Brokerage Fees

In addition to the premiums charged by option writers, brokerages also charge fees associated with options. These fees include:

  • Option trading fee: Similar to a regular trading fee, this is charged for buying or selling an option(s). This is fee is charged in addition to the option contract fee and is typically anywhere from $5 to $20.
  • Option contract fee: This is charged for each option contract acquired, and this fee typically ranges from $0.50 to $2.00.
  • Option assignment fee: This is charged to the option writer when his or her option is exercised by the buyer. This fee can vary dramatically between brokerages.
  • Option exercise fee: This is charged to the option holder when he or she exercises the option – either choosing to buy or sell the underlying investment. This fee also varies dramatically between brokerages.

These fees can eat into an investor’s payoff and profit. Brokerages may also charge additional fees related to options. Any investor considering options should understand how their payoff and profit will be affected by brokerage fees and should choose a brokerage that fits their needs and strategy.

Why Use Options?

One of the main reasons investors use options is because options can change the associated risk and return of an investment. In our call and put option examples above, we can see that owning an option on a stock presents a different set of risks and rewards than simply owning the stock itself.

For example, let’s compare owning an Apple stock, which you purchased at $40, to purchasing a call option on an Apple stock with a strike price of $40 and a premium of $5. If the Apple stock falls in value to $30 a share, you will lose $10 if you own the stock, but only $5 if you have the option. If the stock price rises to $50, you will gain $10 if you own the stock, but only $5 if you exercise the option. Options also allow investors to invest in a financial asset with very little cash outlay. In the example above, the investor who purchased the stock had to pay $40, whereas the investor who purchased the option only had to pay $5 initially.

Options can be combined with each other or other investments to further change the associated risks and returns. For example, an investor might purchase a share of a stock and also a put option on this stock in a strategy known as a protective put. As the name implies, a protective put is a strategy used to “hedge” or protect against the risk of the stock price declining substantially.

Another strategy, called a straddle, occurs when an investor buys a call and a put option on the same stock. In this case, an investor believes that a stock will move up or down by a great deal, but is unsure of which direction. They are essentially making a bet that the stock will be subject to a lot of volatility. These are just a couple of the ways that options can be combined to create more complex investing strategies.

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