Investors use options to speculate (bet) on market price movements, protect portfolios from risk, and generate income. Each approach comes with its own risks, benefits, and typical users.
Options are contracts between two parties:
For example, if an option buyer has the right to purchase stock at $50, the option seller must sell the stock at $50 if the buyer exercises.
Options don’t last forever. Every option has a defined expiration date. Most options expire within nine months after issuance*, though longer-term options exist. The option buyer has until expiration to exercise their right. If the option isn’t exercised by expiration, it expires and no longer exists. Standard options with expirations of up to nine months typically expire on the third Friday of the expiration month at 11:59pm ET**.
*Like most securities, options are issued to investors and then traded in the secondary market. Option issuance is unique compared with other securities; we’ll cover this concept later in this unit.
**Options primarily trade in Chicago on the CBOE (Chicago Board Options Exchange). Chicago is in the Central time zone, which is one hour behind Eastern. When you see test questions on expiration, watch the time zone carefully.
While many options expire within nine months of issuance, there are exceptions:
Options are derivative securities, meaning their value is derived from price changes in an underlying asset. The underlying asset could be a stock, an index, a currency, or a commodity. When the market value of the underlying asset changes, the option’s value tends to change as well.
For example, an option that allows an investor to buy stock at $50 becomes more valuable as the stock’s market price rises. If the market price rises to $90, the option allows the holder to buy the stock $40 below market value. The higher the market price rises, the more valuable that right becomes (and vice versa).
There are two primary types of options contracts:
Equity (stock) options derive their value from price fluctuations of a specific stock. For example, if you bought or sold an Apple Inc. (ticker: AAPL) option, you’d focus on Apple’s stock price. Depending on the option you invest in, you may make money if Apple’s stock price falls, stays flat, or rises. You could use an Apple option to speculate on its price, protect an Apple stock position, or generate additional income.
Index options derive their value from fluctuations in a specific index’s value. For example, you could invest in an S&P 500 index option that may provide a return if the index value falls, stays flat, or rises. Index options are often used to speculate on broad market movements, generate income, or protect an entire portfolio from market risk.
Options can feel like a new language at first. A big part of that language is how we describe buying and selling contracts.
Long is a term used across the securities industry. If an investor is long a security, they purchased it and still hold it. With options, the idea is similar: when an investor goes long an option, they buy a contract that gives them a specific right. Investors who are long options are called holders. A holder has the right to buy or sell an asset at a particular price (depending on the contract).
The cost of an option is its premium. Option buyers pay a premium to purchase the option, and in return they receive the right described in the contract. In general, the more valuable the right, the higher the premium.
For example, if a stock is trading at $70 and an option provides the right to buy the stock at $50, the premium will be at least $20 per share. Premiums are determined in the options market and move based on supply and demand. More demand tends to push the premium higher (and vice versa).
Because premiums can be expensive, holders need the option to generate enough value to offset its cost. When you buy an option, you incur a debit (a cost) to go long.
A worst-case outcome for a holder is for the option to expire unused. If that happens, the holder’s loss equals the premium paid (this is the holder’s maximum potential loss).
Assume an investor buys an option that provides the right to buy a stock at $50. If the stock’s market price falls to $40, the buyer won’t use the option. There’s no reason to exercise the right to buy at $50 when the stock can be bought in the market for $40. In this situation, the option has no intrinsic value.
Intrinsic value is the profit the holder would make by exercising the option. When exercising isn’t profitable (as in the $50 right vs. $40 market price example), the option has no intrinsic value.
Options with no intrinsic value are “out of the money” (OTM). In the example above, the option is out of the money by $10. If an option is still out of the money on the expiration date, it expires worthless. The holder then absorbs the maximum potential loss: the premium paid.
Now assume the investor has the right to buy the stock at $50 and the stock price rises to $75. The holder can exercise, buy at $50, and then sell in the market at $75. In this case, the option has intrinsic value. Specifically, it has $25 of intrinsic value. An option with intrinsic value is “in the money” (ITM).
In summary, option purchasers are long options and are called holders. Holders pay premiums (creating a debit) to gain the right to transact at a fixed price before expiration, and they hope the option goes in the money (gains intrinsic value).
When investors sell an option, they go short. With options, the terms sell and short are used interchangeably.
Selling an option can involve significant risk. To provide the holder’s rights, the seller obligates themselves to do something they may not want to do later. The seller accepts that obligation because they receive a premium in return.
Option sellers receive a premium when they go short options, so they are credited the premium. That premium is the immediate benefit of selling the option. In the best-case scenario for the seller, the option expires worthless and the seller’s obligation disappears.
Option sellers are also called writers. The idea is that the seller is “writing” a contract and selling it to another investor.
Writers want the options they sell to expire worthless, meaning the option never gains intrinsic value. Remember: intrinsic value is the holder’s profit if the option is exercised. The holder’s profit is the writer’s loss. The more intrinsic value the contract has, the more the writer loses. So the writer wants the option to stay out of the money (OTM) and avoid intrinsic value. The examples below show how this works.
An investor sells an option that gives the holder the right to buy stock at $50. The investor (the option seller/writer) is obligated to sell the stock at $50 if the holder exercises.
If the market price falls to $45 per share, the holder won’t exercise. There’s no reason to buy at $50 when the market offers $45. If the market price stays there through expiration, the writer isn’t forced to do anything. The writer earns the maximum gain: the premium received when the option was sold. The option has no intrinsic value and is out of the money at expiration.
Conversely, if the stock rises to $70 per share, the holder will exercise the right to buy at $50. The contract has $20 of intrinsic value and is in the money.
When a writer’s option is exercised, the writer is assigned and must perform the obligation. In this example, the writer must sell the stock at $50. If the writer doesn’t already own the stock, they must buy it in the market at $70 and then sell it to the holder at $50. That locks in a $20 per share loss. The writer still keeps the premium, but the premium may not offset the loss created by assignment.
In summary, option sellers are short options and are called writers. Writers receive premiums (creating a credit) in return for obligating themselves to perform a transaction at a fixed price. Writers hope their options remain out of the money (without intrinsic value) and expire worthless.
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