Introduction to Options

What are options and how do they work?

In simple words, Options are financial contracts that give you the right, but not the obligation, to buy or sell a stock at a fixed price before a specific date.

It's like making a reservation — you secure a price for something now, but you don’t have to commit to buying it unless you want to.

Yeah, options can be confusing at first, but let’s break it down in a way that actually makes sense!

Think of it like this:

You want to buy the newest iPhone, but you’re not sure if the price will go up or down next month. So, you go to Apple and say,

“Hey, hold this iPhone for me at today’s price, and I’ll decide later if I want to buy it. If the price goes up, I’ll still get it at today’s lower price. If the price goes down, I’ll walk away.”

Apple agrees, but there’s a catch — they won’t do this for free. You have to pay them a premium (a small deposit) to reserve the phone.

Now, if the price of the iPhone goes up, you get a great deal because you can still buy it at the lower price you locked in. But if the price goes down, you’re not forced to buy it—you can walk away.

The only downside? You lose the premium you paid.That’s exactly how options work in the stock market. You pay a premium for the right to buy or sell a stock at a set price before a certain date.

If the stock moves in your favor, you lock in a great deal. If it doesn’t, you can walk away—but you won’t get your premium back.

Options are used in different ways. Some traders use them to bet on whether a stock’s price will go up or down, while others use them to protect their investments from potential losses.

Another reason traders like options is that they provide leverage, allowing them to control a larger amount of stock with less money.

While options can be a powerful tool for making money in the market, they also come with risks. Since they have an expiration date, if the stock doesn’t move as expected before the option expires, it becomes worthless. That’s why understanding how options work and using them is important for any trader looking to take advantage of them.

The three key parts of an pption

Before jumping into options trading, it’s essential to understand the key components that make up an options contract.

Strike Price: This is the price at which an option can be exercised.

Expiration Date: This is the date when the option contract expires. After this date, the option becomes worthless if it hasn’t been exercised or sold.

Option Premium: This is the price you pay to buy an option.

Now that you know the key parts of an option, let’s look at the different types of options and how they work.

Types of options

There are two types of options: calls and puts.

A call option is a contract that gives you the right to buy a stock at a specific price before a set expiration date. Traders buy call options when they believe a stock’s price will rise. If the stock does go up, the call option increases in value and the trader can sell it for a profit or use it to buy the stock at a discount.

For example, Let's say Tesla stock is currently trading at $300. If you think the price will go up, you might buy a call option with a strike price of $310 that expires in one month. If Tesla’s price goes to $330 before expiration, your option gains value because you can still buy at $310 while the market price is $330. You can either sell the option for a profit or exercise it to buy the stock at a lower price.

A put option is the opposite. It gives you the right to sell a stock at a set price before expiration. Traders buy put options when they expect a stock’s price to drop. If the stock does fall, the put option becomes more valuable because it allows the trader to sell the stock at a higher-than-market price, locking in a profit.

Now, let’s say you expect Tesla’s price to drop instead. You buy a put option with a strike price of $290. If Tesla falls to $270, your put option gains value because you can sell at $290 while the market price is lower at $270. Again, you can either sell the option for a profit or exercise it to sell the stock at a better price.

A call option makes money when a stock rises, while a put option makes money when a stock falls.

Options greeks

Alright, so now you know what call and put options are… but wait, there’s more!

Meet the Options Greeks – the squad that secretly controls how your options move.

Think of them like the hidden forces of the options world, kind of like the weather.

Ignore them, and you might get caught in a financial thunderstorm!

So, let's understand what options Greeks are

Option Greeks are mathematical measurements that help traders understand how an option’s price changes based on different factors. They are called “Greeks” because each one is represented by a Greek letter. These measurements help traders manage risk and predict how an option will behave as the stock price, time, and market volatility change.

There are four main Option Greeks that: Delta, Gamma, Theta, and Vega.

Delta – How Much the Option Price Moves with the Stock Price

Delta tells you how much an option’s price will change if the stock price moves by $1.

For call options, delta is a number between 0 and 1. A delta of 0.50 means that if the stock price increases by $1, the option price will increase by 50 cents. If the stock drops by $1, the option will lose 50 cents in value.

For put options, the delta is negative, ranging from -1 to 0. A put option with a delta of -0.50 means that if the stock price drops by $1, the option price will increase by 50 cents. If the stock rises, the option will lose value.

A delta closer to 1 or -1 means the option moves almost the same as the stock. A delta closer to 0 means the option is far from being profitable and won’t change much when the stock moves.

Gamma – How Fast Delta Changes

Gamma measures how quickly the delta changes as the stock price moves. Delta tells you how much the option price moves, and Gamma tells you how fast Delta itself changes.

For example, if a call option has a delta of 0.50 and a gamma of 0.10, then if the stock price rises by $1, the new delta will be 0.60 instead of 0.50. This means the option will become more sensitive to stock price changes.

High gamma means delta can change quickly, making the option price more volatile. This is why it is important to pay attention to gamma, especially for options that are close to the current stock price.

Theta – The Effect of Time Decay

Theta measures how much an option loses value over time. Options lose value every day, even if the stock price doesn’t move, because as expiration gets closer, the chance of the option ending up profitable decreases.

If an option has a theta of -0.05, it means the option will lose 5 cents per share per day just from time decay. Since one options contract represents 100 shares, this means a loss of $5 per day.

Theta is like the sand slipping through an hourglass — it never stops, and once it’s gone, you can’t get it back.

Vega – The Effect of Volatility on Option Prices

Vega measures how much an option’s price will change based on market volatility.

If an option has a vega of 0.10,  a 1% increase in the underlying asset's volatility will increase the option's price by $0.10 per share. Since each contract represents 100 shares, this results in a $10 increase per contract. Likewise, a 1% decrease in volatility lowers the option’s price by $0.10 per share or $10 per contract.

When market volatility is high, option prices go up because traders expect big price swings. When volatility is low, option prices drop because traders expect smaller price movements.

Implied volatility – How volatility affects option prices

Implied Volatility (IV) is one of the most important factors in option pricing. It represents how much the market expects a stock to move in the future. Higher IV means traders expect big price swings, while lower IV means traders expect the stock to stay relatively stable.

Unlike historical volatility, which looks at how much a stock moved in the past, implied volatility is forward-looking. It is based on trader expectations and supply and demand for options contracts.

But how IV Impacts Option Prices

When IV is high, option prices go up. Traders are willing to pay more for options because they expect large price movements. This happens during earnings reports, major news events, or market uncertainty when nobody knows which direction the stock will move, but they expect it to move a lot.

When IV is low, option prices become cheaper. This means traders don’t expect much movement in the stock, so they aren’t willing to pay high premiums for options.

For example, if a stock has been trading in a tight range with no big news expected, IV will be low, and options will be cheaper. But if an earnings announcement is coming up, IV will rise because traders expect a big move after the report. This makes option premiums more expensive, even if the stock hasn’t moved yet.

High vs. Low IV and What It Means for Traders

High IV means

• Options are more expensive.
• Better for selling options because you can collect a higher premium.
• It is risky to buy options since IV can drop after a big event, reducing the option’s price (this is called IV crush).

Low IV means

• Options are cheaper.
• Better for buying options because premiums are lower.
• It is not ideal for selling options since you collect less premium.

But Why IV Matters in Options Trading

You must always check implied volatility before buying or selling options. Many beginners make the mistake of buying options when IV is high, expecting a big stock move, only to see their option lose value even if the stock moves in their favor. This happens because IV drops after the expected event, which lowers the option price.

Understanding IV helps traders avoid overpaying for options and time their trades better. Some strategies, like selling covered calls or credit spreads, work best when the IV is high while buying options work better when the IV is low.

What happens when an option expires?

Every option has an expiration date. When that day arrives, one of three things happens.

If the option is in the money (ITM), meaning the stock price is above the strike price for calls or below for puts, the option has value and can be exercised or sold.

If the option is out of the money (OTM), meaning the stock didn’t reach the strike price, the option expires worthless, and you lose what you paid for it.

If the option is at the money (ATM), meaning the stock price is exactly at the strike price.

Most traders don’t wait for options to expire. Instead, they sell their options before expiration to lock in profits or cut losses.

Intrinsic and Extrinsic Value

When trading options, you’ll often hear about intrinsic value and extrinsic value. These two terms are key to understanding how an option is priced. Don’t worry, we’ll break it down in a way that its easier to understand.

Intrinsic value: The “real” value of an option

Intrinsic value is the part of an option’s price that comes from how much it’s already in the money (ITM). In simple terms, it’s the amount of profit you’d have if you exercised the option right now.

Call Option: Intrinsic value is how much the stock price is above the strike price.

Put Option: Intrinsic value is how much the stock price is below the strike price.

Let’s say you buy a call option with a strike price of $50, and the stock is currently trading at $60. Since the option lets you buy at $50 while the market price is $60, the intrinsic value is $10 ($60 - $50).

If a put option has a strike price of $50 and the stock is at $40, its intrinsic value is $10 ($50 - $40).

If an option is out of the money (OTM)—meaning a call’s strike price is above the stock price or a put’s strike price is below the stock price — it has zero intrinsic value.

Extrinsic value: The “time and hype” value

Extrinsic value is the extra price you pay on top of the intrinsic value. This comes from factors like time until expiration and market demand. Even if an option has no intrinsic value (because it’s out of the money), it can still have extrinsic value.

What affects extrinsic value?

Time to Expiration: More time means more chances for the stock to move in your favor, so the extrinsic value is higher. As expiration gets closer, this value shrinks—a process called time decay.

Implied Volatility: If traders expect big price swings, option prices go up, adding to extrinsic value.

Example:

Let’s say you buy a call option with a strike price of $50 when the stock is trading at $48. This option is out of money, so it has zero intrinsic value, but it still has extrinsic value because there’s a chance the stock could go above $50 before expiration.

Why traders use options: Hedging, speculation, leverage

Options aren’t just for guessing stock prices. Traders use options for three main reasons: hedging, speculation, and leverage.

Hedging – Protecting your investments

Think of hedging as buying insurance for your stock. Let’s say you own a stock, but you’re afraid its price might drop. Instead of selling your shares, you buy a put option.

If the stock price falls, your put option gains value, helping to cover the loss in your stock investment. This way, even if the stock price goes down, your put option makes money, reducing your overall loss.

Speculation – Making bets on stock prices

Some traders use options to bet on stock price movements. Instead of buying a stock for full price, they buy options because they are cheaper.

• If they think a stock will go up, they buy a call option.
• If they think a stock will go down, they buy a put option.

If the price moves in their favor, they sell the option for a profit. If it doesn’t, they lose only the amount they paid for the option.

Leverage – Controlling more with less money

One of the biggest reasons traders use options is leverage. A single-option contract lets you control 100 shares of stock without having to pay for all of them upfront.

For example, instead of spending $10,000 to buy 100 shares of a stock at $100 per share, you could buy an option for a few hundred dollars and still profit if the stock moves in your favor.

This can lead to big profits but also big losses if the trade doesn’t go your way. That’s why traders must be careful when using leverage.

How to Trade Options

Before trading options, you need to be approved by your broker. This usually involves applying for options and margin trading approval, as brokers want to ensure you understand the risks.

Once approved, there are four main ways to trade options:

Long call

A long call is when you buy a call option because you think the stock price will go up. This gives you the right to buy the stock at a set price before the option expires. If the stock goes higher than that price, you can buy it cheaper than the market and make a profit. If the stock doesn’t move up, you lose only the small amount you paid for the option.

Let's say a stock is trading at $50, and you buy a call option with a $50 strike price for $2. If the stock goes to $60, you can still buy it for $50, making a $10 profit per share (minus the $2 you paid). If the stock stays below $50, the option expires worthless, and you only lose the $2 premium.

Short call

A short call is when a trader sells a call option, expecting the stock price to stay the same or go down. The trader collects money upfront (the premium), but if the stock price goes up too much, they can lose a lot of money.

For example, a trader sells a call option with a $50 strike price for $3 per share. If the stock stays below $50, the option expires, and the trader keeps the $3 premium as profit. But if the stock rises to $60, they must sell it for $50, even though it is worth $60. If they don’t own the stock, they must buy it at the market price, losing $10 per share while keeping only the $3 premium. The higher the stock goes, the bigger the loss, making this a very risky strategy.

Long put

A long put is the opposite. You buy a put option because you believe the stock price will go down. This gives you the right to sell the stock at a set price before expiration. If the stock drops, you can sell it for more than the market price, making a profit. If the stock doesn’t fall, the option expires, and you only lose the amount you paid for it.

Suppose a stock is trading at $50, and you buy a put option with a $50 strike price of $3. If the stock falls to $40, you can still sell it for $50, making a $10 profit per share (minus the $3 premium). If the stock stays above $50, the option expires, and you lose the $3 premium.Short put

A short put is the opposite. A trader sells a put option, expecting the stock price to stay the same or go up. They collect a premium, but if the stock price drops, they may have to buy the stock at a higher price than it’s worth.

For example, a trader sells a put option with a $50 strike price of $4 per share. If the stock stays above $50, the option expires, and they keep the $4 premium as profit. But if the stock drops to $40, they must buy it for $50, even though it’s only worth $40. While they still keep the $4 premium, their total loss is $6 per share.

A short put can still be risky, but it has a limit since a stock can’t go below zero. Some traders use short puts as a way to buy stocks at a discount since they only have to buy the stock if it drops below the strike price.

Where are options traded?

Options are traded on major exchanges, just like stocks. The Chicago Board Options Exchange (CBOE) is the largest U.S. options exchange, followed by the Nasdaq Options Market and the NYSE American Options Exchange.

Most brokers allow options trading, but you may need to apply for options trading approval based on your experience level. Brokers want to make sure you understand the risks before they let you trade options.

Final thoughts

Options trading gives you the ability to profit from stock movements with less money, hedge your investments, and use leverage to maximize gains.

But options also come with higher risks than regular stock trading. Unlike stocks, options expire, and if you don’t manage them properly, you could lose your entire investment.

If you’re new to options, the best approach is to start small, learn the basics, and practice on a demo account before risking real money.

The more you understand options, the better you’ll be prepared to trade successfully.

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