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Options 101

Beginner's breakdown to options trading:

What is an options contract?

An options contract is an agreement between two parties: a buyer and a seller (also called the “writer”).

At its most basic level, the contract gives the buyer the right, but not the obligation, to buy or sell a stock at a specific price (called the strike price) before a certain date (the expiration date).

  • The buyer pays a cost (known as the premium) for this right.
  • The seller collects the premium and, if the buyer chooses to exercise the option, has the obligation to deliver on the terms of the contract. Each contract guarantees 100 shares. 

Don’t worry, this will make more sense when we share an example. 

The Two Basic Types of Options

  • Call Options: Right to buy at a set price (strike). Bullish tool.
  • Put Options: Right to sell at a set price. Bearish tool.

Example:

Let’s say Apple stock is trading at $250 and you think the stock is going to increase by $10 in the next month.

  • You buy a call option with a strike price of $260 that expires in one month. The price of the contract will depend on different factors that we'll cover shortly, but for the sake of this example, let’s say it’s $500. (You’ll see this written as 5.00 on the option chain in your broker because every contract represents 100 shares, so you’ll multiply the 5.00 x 100 to get the actual price).

  • This means you have the right to buy 100 shares of Apple at $260 anytime before expiration, even if Apple rallies to $280.

Two possible outcomes:

  1. Stock goes up:

    Apple rises to $280 before expiration. This will increase your option contract's value because it still guarantees 100 Apple shares at $260 even though Apple is far above that. So if you "exercise" this contract, you're already $20 in profit per share.
    • Your option gives you the right to buy at $260.
    • You could sell the option itself for about $20 in value (the difference between $280 and $260) × 100 = $2,000.
    • After subtracting the $500 cost, your profit is $1,500.
  1. Stock stays below $260:

    Apple stays at $255 or lower.

    • Your option expires worthless. Where did the money go? The option seller / writer collected all of it. So option sellers earn the premium you pay if the option expires worthless or if it goes down in value. 

    • At expiration, you lose the $500 premium you paid, but nothing more.

An option’s premium is made up of two components:

  1. Intrinsic Value (if the option is already “in the money”).

    • Example: If Apple is $265 and your call strike is $260, there’s $5 of intrinsic value.

  2. Time Value (extra value for the potential that the stock might move further before expiration).

    • Even if the option is “out of the money” (say Apple $250, strike $260), the premium could still be $5 because traders are paying for the possibility that Apple will rise above $260 before expiration.

Key Terms You Must Know

  • Strike Price: The target price you have for the stock by expiration. If you're in calls, you want it to be above this price. If in puts, you want it to be below. 

  • Expiration Date: The deadline for using the option. Swing traders should give options 4-6 weeks until expiration. For longer term positions, consider LEAPs, which we'll cover on a different blog.

  • Premium: The cost of the option contract. This is the intrinsic + extrinsic values combined. The deeper ITM the contract is, the more expensive. And the longer till expiration, the more expensive as well. 

  • In the money (ITM): an option contract is "in the money" if the strike has been achieved. For example, if you're in a call option with a strike of $100, the option contract is in the money only if the stock is worth $99 or less. The higher "in the money" the contract is, the more expensive. 

  • Out the money (OTM): an option contract is "out the money" if the stock is still trading below the strike price (for calls). For example, if you're in a call option with a strike of $100, the option contract is out the money if the stock is worth $101 or more. The lower " out the money" the contract is, the more expensive. 

  • ITM / OTM PUTS: The rules are the opposite. If you're in a put, you want the stock to go down in order for your contract to go up in price, so if the stock is trading less than the strike then it's ITM and if it's above the strike then it's OTM.
  • Contract Size: Typically 1 contract = 100 shares.

Why Traders Use Options

  • Speculation: Amplify returns with less capital. This has become the most popular among retail investors. Let's think back to the Apple example above. The stock was $250 and rallied to $280, only a $30 move. But that $30 move grew the option contract's value by $1,500. Why? Because that option guarantees 100 shares at a price...and the higher the stock went, the more value the contract now brings to its buyer. You don't have to hold the option until expiration, you can sell it back to the market and collect your profits. 

  • Hedging: Protect a portfolio from downside risk. If you feel a pull back is coming on the market and you don't want to exit your current positions, you can buy puts or sell calls. 

  • Income: Sell options (covered calls, cash-secured puts) to generate premiums.

The Greeks (Risk Measures)

  • Delta: Sensitivity to stock price.
  • Theta: Time decay (how options lose value daily).
  • Gamma: Rate of change of delta.
  • Vega: Sensitivity to volatility.
  • Rho: Sensitivity to interest rates.

Risks to Watch Out For

  • Options can expire worthless, leading to 100% premium loss.

  • Time decay works against buyers every single day. BUY MORE TIME. Don't cheap out on this. Many traders are often right about direction, they just don't give their contracts enough time. 

  • High leverage can magnify both gains and losses. It's not all gains. If a stock goes against your option strike, it can wipe out premium quickly.
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