Options: How They Work

Introduction

Options are contracts that give a trader or investor a right tied to an underlying security without forcing them to act. They sit in the derivatives family and derive value from stocks, indexes, ETFs or other assets.

Because options can amplify returns while also limiting certain losses, they attract a wide range of market participants—from investors hedging exposure to traders pursuing speculative opportunities.

Why it matters

Understanding options expands the toolkit available for managing risk and targeting specific market outcomes. They can increase leverage, create income streams, or protect positions, depending on how they’re used.

How Options Work

An option is an agreement between a buyer and a seller. The buyer pays a price, called a premium, in exchange for a contractual right. What that right allows depends on the type of option involved.

Two basic types exist: calls and puts. Each contract also specifies a strike price and an expiration date, and most standard stock options represent 100 shares per contract.

Types of Options

Call Options

A call grants the buyer the right to purchase the underlying asset at the strike price on or before expiry. Calls gain value when the underlying asset moves higher.

Buyers of calls have limited downside—the premium paid—while potential upside can be large if the asset climbs above the strike.

Put Options

A put gives the buyer the right to sell the underlying asset at the strike price on or before expiration. Puts become more valuable as the underlying falls in price.

Investors use puts as insurance against declines or to express a bearish view without shorting the underlying directly.

American vs. European Style

Options are often labeled American or European, which refers only to exercise rules, not geography.

American-style options can be exercised any time before they expire. European-style options can be exercised only at expiration.

Because early exercise has value, American-type contracts often trade at slightly higher premiums than otherwise similar European contracts.

Contract Details and Timing

Standard equity options typically control 100 shares. The premium quoted per option is multiplied by 100 to produce the total cash cost of one contract.

Expiration cycles vary. Some options expire daily, others weekly, monthly, or quarterly. Most monthly stock options historically expire on the third Friday of the expiration month.

Why it matters

Contract size and expiration determine cost, leverage and the timing risk you face. Choosing strike and expiry ranges shapes whether you’re betting on a near-term move or positioning over a longer horizon.

Options Strategies and Spreads

Single options are building blocks. Combining bought and sold calls and puts creates spreads designed for specific risk-return profiles.

• Bull call spread: buy a call and sell a higher-strike call to limit cost and upside.
• Protective put: buy a put while holding the underlying to limit downside.
• Iron condor: sell an out-of-the-money call and put while buying further out-of-the-money options to cap losses.

Spreads allow traders to tailor exposure to volatility, direction and time decay while controlling maximum loss and potential gain.

Options Risk Measures: the Greeks

Options are influenced by multiple moving parts. Traders use Greek metrics to quantify how option values shift when market conditions change.

These measures are derivatives of pricing models and help in pricing, hedging and risk monitoring.

Delta

Delta measures how an option’s price moves for a small change in the underlying’s price. For calls, delta ranges from 0 to 1; for puts, from 0 to -1.

Delta also approximates the hedge ratio—how many shares to buy or sell to offset option exposure. Some traders interpret delta as a rough probability of finishing in-the-money.

Theta

Theta captures time decay: how much an option’s value is expected to drop as one day passes, all else equal. Options lose extrinsic value as expiry nears, especially at-the-money contracts.

Buyers of options generally suffer from negative theta, while sellers can benefit from positive theta if other conditions remain stable.

Gamma

Gamma measures how delta changes as the underlying moves. A high gamma means delta can shift quickly after small price moves, making hedging more challenging.

Gamma is largest for at-the-money options and increases as expiration approaches, meaning short-term movements can change exposure rapidly.

Vega

Vega shows sensitivity to implied volatility. If implied volatility rises, option premiums typically rise; when volatility falls, prices drop.

Vega is higher for options with longer time to expiration and for at-the-money strikes.

Rho

Rho measures sensitivity to interest rates. It is usually small compared with other Greeks but can matter for long-dated options.

Minor Greeks

Beyond the core Greeks, traders sometimes monitor second- and third-order measures—like vomma, vanna, zomma and others—that capture curvature and interaction effects.

Why it matters

Greeks let traders deconstruct option exposure into manageable parts. They’re essential when hedging or running multi-leg strategies that must react to price, time and volatility changes.

Advantages and Drawbacks

Advantages

• Leverage: control more exposure for less capital outlay than buying shares outright.
• Defined downside for buyers: the premium paid is the maximum loss when buying options.
• Flexibility: options can be used to hedge, generate income, or express directional views.

Drawbacks

• Complexity: pricing involves multiple variables and models, increasing operational and conceptual difficulty.
• Time decay: long option holders must overcome theta erosion to profit.
• Potentially large losses for sellers: writing uncovered calls or puts can expose a trader to substantial risk.

Practical Example

Imagine a stock trading at $108. You expect it to rise and buy a one-month call with a $115 strike for $0.37 per share. One contract covers 100 shares, so the premium costs $37 plus fees.

If the stock reaches $116 at expiry, the option’s intrinsic value is $1.00. After subtracting the $0.37 premium, your net gain is $0.63 per share, or $63 for the contract—an outsized percentage return relative to the stock’s move.

If the stock drops below $115, the option may expire worthless and the loss is limited to the $37 premium. In contrast, owning 100 shares would expose you to a much larger dollar loss.

Why it matters

This example shows how options can multiply percentage returns on favorable moves and limit downside in unfavorable scenarios—but only if the price moves enough to offset the premium and time decay.

Common Terminology

• At-the-money (ATM): strike roughly equal to the underlying price.
• In-the-money (ITM): option has intrinsic value (call strike below market; put strike above market).
• Out-of-the-money (OTM): option has no intrinsic value; value comes from time and volatility.
• Premium: the market price paid to buy the option.
• Strike price: the price at which the option owner can buy (call) or sell (put) the underlying.
• Underlying: the asset the option references (stock, ETF, index, etc.).
• Implied volatility (IV): the market’s expectation of future volatility reflected in option prices.
• Exercise and assignment: when an owner uses the option’s right, and the seller is required to fulfill the contract.
• Expiration: the last date the option can be exercised.

How Investors Use Options

Options serve several practical roles in portfolios. Investors can use them to hedge downside, generate income, or express directional convictions with limited capital.

Examples include buying protective puts for a stock holding, selling covered calls to earn premiums against long stock, and constructing spreads to target defined risk profiles.

Options vs. Futures

Both are derivatives, but they differ fundamentally in obligations. Options grant a right without obligation, while futures create a binding obligation to buy or sell at expiry.

That distinction affects margin requirements, settlement practices and the kinds of risk participants assume.

Is an Options Contract an Asset?

Yes. An option is a tradable financial asset. It can be bought and sold in markets before expiration, and its value fluctuates with the underlying, time, volatility and other inputs.

Key Takeaways

• Options give holders a choice: the right to buy or sell at a set price within a set time frame.
• Calls reward upside moves in the underlying; puts gain when the underlying falls.
• Greeks quantify the sensitivities that drive option prices: price moves, time decay, volatility and interest rates.
• Using options requires understanding tradeoffs: leverage and flexibility come with complexity and, for sellers, potentially significant risk.

Final Thoughts

Options are versatile tools that can be adapted to many market goals. They are particularly useful for managing risk and creating tailored exposures that are difficult to achieve with cash equities alone.

Before trading options, make sure you understand contract mechanics, strategy specifics and how market variables affect outcomes. For many investors, simulated trading or incremental exposure while learning can help avoid costly mistakes.