Sonith ManakkatAn option is a contract. It is one of the most misunderstood tools in trading, partly because the words sound technical and partly because the payoffs are lopsided. This part explains options with everyday pictures first, then gives an Expert view with the precise terms. Every number here is illustrative: invented round figures chosen to make the arithmetic easy, not a description of any real market.
The idea: a right, not a duty
An option has three ingredients you will see everywhere.
- Strike priceThe agreed price at which the right can be used
- ExpiryThe date the right ends
- PremiumThe price paid by the buyer to the seller for the contract
Expert viewFormal definitions
An option is a derivative: its value depends on the price of an underlying (a share, an index and so on). A call gives its holder the right, but not the obligation, to buy the underlying at the strike on or before expiry (depending on style). A put gives the right to sell for the strike. The buyer (holder, long) pays the premium and has the right. The seller (writer, short) receives the premium and takes the obligation if the buyer uses the right. Options are usually traded in standard contracts, each covering a fixed quantity of the underlying (the contract size or lot), so one contract means many units, and the payoff scales with that quantity.
Calls and puts
Call: the right to buy
- Reserve a purchase price today
- Becomes more valuable when the underlying rises
Put: the right to sell
- Works like insurance on something you hold
- Becomes more valuable when the underlying falls
Whether an option is worth using at a given moment has a name.
- In the moneyThe share is above 100, so the right is worth using
- At the moneyThe share is about 100
- Out of the moneyThe share is below 100, so the right has no use right now
For a put it is the other way round: a put with strike 100 is in the money when the share is below 100.
Expert viewIntrinsic value and time value
The premium has two parts. Intrinsic value is what the option would be worth if used right now: for a call, the underlying price minus the strike, or zero if that is negative; for a put, the strike minus the underlying price, or zero. Time value is the rest of the premium: what the market pays for the chance that the option becomes more valuable before expiry. An out-of-the-money option has no intrinsic value, so its whole premium is time value. At expiry time value is zero, so the option is worth only its intrinsic value.
What happens at expiry
Take a share priced at 100, strike 100 and premium 5 (all illustrative, ignoring costs and the contract size). The payoff at expiry depends only on where the share ends up. Payoff here means the buyer's or seller's gain or loss on the option itself, premium included.
Buyer of a call
| Share at expiry | Option worth | Payoff (buyer of call) |
|---|---|---|
| 80 | 0 | -5 |
| 90 | 0 | -5 |
| 100 | 0 | -5 |
| 110 | 10 | +5 |
| 120 | 20 | +15 |
The shape: a flat loss of 5 on the left, then a line rising once the share passes the strike. The break-even is 105 (strike plus premium). The loss can never exceed the premium paid.
Buyer of a put
| Share at expiry | Option worth | Payoff (buyer of put) |
|---|---|---|
| 80 | 20 | +15 |
| 90 | 10 | +5 |
| 100 | 0 | -5 |
| 110 | 0 | -5 |
| 120 | 0 | -5 |
The shape is the mirror image: a line rising to the left, flat loss of 5 on the right. Break-even is 95. Again the loss is limited to the premium.
Seller of a call and seller of a put
The seller's payoff is the buyer's with the sign reversed, because one side's gain is the other side's loss.
| Share at expiry | Seller of call | Seller of put |
|---|---|---|
| 80 | +5 | -15 |
| 90 | +5 | -5 |
| 100 | +5 | +5 |
| 110 | -5 | +5 |
| 120 | -15 | +5 |
Buyer
- Pays the premium up front
- Worst loss is the premium
Seller
- Receives the premium up front
- Loss grows as the share moves against the position
- 5most a buyer can lose per unit
- 5most a seller can receive per unit
- 15loss for a call seller if the share ends at 120
Expert viewReading payoff shapes
At expiry the payoff of a long call is max(S - K, 0) minus the premium; of a long put, max(K - S, 0) minus the premium (S the underlying price, K the strike). These are kinked, not straight lines, which is why options are called non-linear: a share has a constant payoff slope, while an option's slope changes at the strike. Short positions mirror them. Before expiry the curve is smoother, because time value remains. These tables ignore trading costs, taxes, the time value of money and early exercise.
- Buyer to Seller The buyer pays the premium up front, and the seller keeps it either way.
- Buyer (to itself) The buyer may use the contract, or not.
- Seller (to itself) The seller must meet the obligation if the buyer uses the right.
- Buyer to Seller Only if worth using. A seller is chosen, which is called assignment.
- Seller to Buyer (reply) Settlement: the underlying changes hands, or the cash difference is paid, depending on the contract.
Takeaway. The buyer pays first and chooses later. The seller is paid first and can only wait.
Why time value fades
- Contract agreed
Buyer pays the premium, seller receives it
- Time passes
Time value shrinks, a little each day, speeding up near the end
- Underlying moves
Intrinsic value may appear or disappear
- Expiry
Time value is zero, only intrinsic value is left
- Settlement
Closed out, exercised, or expires worthless
Decay works for the seller and against the buyer, but it does not remove the seller's risk: a large move can outweigh many days of decay.
Expert viewDecay is not linear
Time value does not fall in a straight line. For an at-the-money option it tends to fall faster as expiry nears, roughly with the square root of the time left in simple models. The measure of this is called theta, covered in the next part, which also covers how implied volatility affects the premium.
Using and settling an option
- Hold itThe right stays open until expiry
- ExerciseUse the right at the strike, if it is in the money
- Close outSell the contract to someone else before expiry
- Let it expireExpires worthless if it has no intrinsic value
When a buyer exercises, a seller is chosen to meet the obligation. This is called assignment. Some contracts settle by delivering the underlying; others settle in cash, paying the difference between the underlying price and the strike.
Expert viewEuropean versus American
A European option can be exercised only at expiry; an American option can be exercised at any time up to expiry. The names say nothing about where they trade. Early exercise adds flexibility and can affect pricing, and many options are automatically exercised at expiry if they are in the money by some set amount, depending on the contract rules. Contract specifications, including size, style and settlement type, are published by the venue, so read them rather than assuming.
- Held to In the money The underlying moves to the useful side of the strike.
- Held to Out of the money The underlying stays on the other side of the strike.
- In the money to Exercised The buyer exercises at the strike.
- In the money to Closed out Another party takes the contract before expiry.
- Out of the money to Closed out Some value may remain, so the contract can be sold.
- Out of the money to Expired worthless With no intrinsic value left, the option ends worthless.
Takeaway. A bought option ends in one of three ways, and doing nothing can end in nothing.
Myths worth dropping
Options are just cheap shares
An option is a different contract: it can expire worthless and its value depends on time as well as price
A buyer's risk is small, so options are safe
The loss is limited to the premium, but the whole premium can be lost, often quickly
Sellers just collect fees
Sellers take on an obligation whose loss can far exceed the premium received
A buyer pays for a right and can lose only the premium. A seller takes an obligation and can lose far more.
Frequently asked questions
Is a bought option always cheaper to lose than a share?
The loss is capped at the premium, which can be the whole amount paid. A share can lose less in a small move, so cheaper in absolute terms is not the same as lower risk in percentage terms.
Why do sellers need a deposit?
Because the obligation can lead to a loss larger than the premium, the seller must show they can meet it.
Does an option have to be exercised?
No. A buyer can close it out, exercise it or let it expire.
Are the numbers here real?
No. All figures are illustrative round numbers to show the arithmetic.