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Options have a reputation for being complicated, and some of them are. The basic contract is simple to describe: a right to buy or sell something at a fixed price, on or before a fixed date.
What makes options demanding is not the definition. It is what a right with a deadline does to risk, for the person who buys it and, even more, for the person who sells it.
What an option is
The SEC describes options as contracts giving the owner the right to buy or sell an underlying asset at a fixed price, on or before a specified future date. They are derivatives: they derive their value from the asset underneath, which can be a stock, a stock index, an exchange-traded fund or another product.
The CFTC’s glossary stresses the key words: the buyer has the right, but not the obligation. The seller, called the writer, takes on the obligation in return for a payment, the premium.
Trading options also takes permission. FINRA notes that a brokerage firm must approve an account for a specific level of options trading, and that investors should read the disclosure document Characteristics and Risks of Standardized Options before they trade.
Calls and puts
- A call: the right to buy the underlying asset at the strike price for a set period. The seller of the call must sell if the buyer exercises.
- A put: the right to sell the underlying asset at the strike price for a set period. The seller of the put must buy if the buyer exercises.
Those two contracts make four basic positions: buying calls, selling calls, buying puts and selling puts. Each carries a different risk.
Reading an option’s terms
The SEC explains the parts of a contract with a sample quote, “ABC December 70 Call $2.20”:
- The underlying: ABC, the stock the contract is written on.
- The expiration: December, when the contract expires. After that date the buyer no longer has any rights, and the option no longer has value.
- The strike price: 70, the price at which the buyer may buy the stock.
- The type: a call, the right to buy.
- The premium: $2.20 per share. A contract generally covers 100 shares, so this one costs $220, paid up front to the seller and not refundable.
The premium depends, the SEC notes, on the stock’s price relative to the strike price, the time left until the contract expires, and how volatile the stock’s price is.
The part of a premium above what the option would be worth if exercised now is its time value. The CFTC notes that the longer the time remaining until expiration, the greater the time value, so as the deadline nears, that part of the price runs out.
What a buyer can lose
For the buyer, the risk is set at the start. FINRA puts it simply: “For the purchaser of an option, the premium paid is your maximum loss.”
That maximum is reached often enough to matter. In the SEC’s example, a buyer pays $220 for a December 70 call on a stock trading at $68. To break even, the stock must rise to $72.20. If the stock is at $65 on the expiration date, the option expires worthless and the whole $220 is gone.
The SEC also names market risk: extreme volatility near an expiration date could cause price changes that leave the option expiring worthless.
A buyer can be right about the direction and still lose, if the move comes too late or is too small to cover the premium.
What a writer can lose
Selling, or writing, an option reverses the shape of the risk. FINRA notes that for the seller, the premium received at the time of the sale is the maximum profit.
The loss can be far larger. The SEC warns that certain types of options contracts can expose writers to unlimited potential losses. Its example is the naked call, sold by someone who does not own the stock: if the buyer exercises, the writer must buy the shares in the market to deliver them, and there is no limit to how high a stock’s price may rise.
FINRA adds that a writer may be assigned and required to fulfill the contract, may be required to deposit significant additional funds, and that the firm has the right to liquidate the position without notice.
Brokerage firms generally do not let investors use margin to buy options, the SEC notes, but they may allow it for selling them, and some of those positions can bring losses that exceed the initial investment.
Why options are a form of leverage
FINRA notes that options offer leverage, meaning the ability to magnify the value or purchasing power of the premium paid. The SEC lists options trading beside margin trading and leveraged ETFs as one of three common leveraged investment strategies.
That is why a small premium can change in value quickly, in either direction. FINRA’s reminder fits: options investors can have a paper profit one day and a paper loss the next.
The takeaway
An option is a right with a price and a deadline. For the buyer, the price is the most that can be lost, and it is lost whenever the deadline arrives before the move. For the writer, the payment is fixed while the risk may have no ceiling.
A written plan says which side of the contract a trader is on, and what that side can cost, before the trade.
Your results will depend on your own decisions, your capital and market conditions, and you can lose money.
