An option is a contract giving you the right, though never the obligation, to buy or sell a share at a fixed price before a set date. You pay a fee for that right, called the premium. A call is the right to buy. A put is the right to sell.

You are not buying the company, as you would with a share. You are buying a right to act on what its share price does. This module explains exactly how that works, in plain English, with worked numbers throughout, and it is the foundation the other six build on.

A share is ownership. An option is a contract

The quickest way to understand an option is to set it against something you already understand.

When you buy a share, you become part owner of a company. You have a claim on its assets and its earnings, and there is no expiry date on your holding. You can sit on it for thirty years and it remains yours.

When you buy an option, you own something quite different. You own a contract with a fixed lifespan, which gives you a right connected to the share’s price. You own no part of the company. You have bought a claim on what the price does, and only until a stated date.

Two consequences follow from that single difference, and almost everything else in this guide is a working out of them. Your option has a deadline, so being right eventually is not the same as being right. And your option is worth something only in relation to the share, so it can lose all of its value while the company carries on perfectly well.

People use options for three broad purposes. To speculate on a price move using far less capital than buying the shares outright. To hedge an existing holding against a fall. And to generate income by selling options to other people. Everything in the rest of this module assembles the pieces you need for all three.

Call options: the right to buy

A call option gives you the right to buy a share at a fixed price, called the strike price, before the expiry date. You buy a call when you expect the price to rise.

Look at the breakeven line, because it contains the lesson that costs beginners the most. It is $53, not $50. You do not start making money the moment the share rises above the strike. You start making money once it has risen above the strike and covered what you paid for the right. The share going from $50 to $52 is a move in your favour on which you still lose.

Your maximum loss is the premium, which is $300 and not a penny more, however far the share falls. Above $53 your profit rises with the share price and has no ceiling in principle. That shape, a loss you capped in advance against a gain you did not, is the defining feature of buying a call and the reason options exist.

Put options: the right to sell

A put option is the mirror image. It gives you the right to sell a share at the strike price before expiry. You buy a put when you expect the price to fall, or when you want to protect something you already own.

As with a call, the buyer’s loss is limited to the premium paid, and the profit grows as the share falls below the breakeven, which here is the strike minus the premium.

One difference from a call is worth noting now, because it comes back in module 3. A call’s profit is theoretically unlimited because a share can keep rising forever. A put’s profit has a ceiling, because the furthest a share can fall is to zero. The two are mirror images in shape but not in size.

The premium: intrinsic value and time value

Every premium is made of two parts, and separating them is the most useful single habit in options pricing, because the two behave in completely different ways.

• Intrinsic value is the profit you could lock in by exercising right now. For a call it is the share price minus the strike, and it never goes below zero. For a put it is the strike minus the share price. This part is arithmetic. There is no opinion in it.
• Time value is everything above intrinsic value. It is what the market charges you for the possibility of future movement. It depends on the time remaining, on implied volatility and on interest rates, and it always decays towards zero as expiry approaches.

Here is why the split matters. Intrinsic value is safe in the sense that it exists right now and can be realised. Time value is a wasting asset that shrinks every day you hold whether or not anything happens. When you buy an option you are buying some of each, and you should know which part of your money is buying which.

At expiry, time value is gone entirely and only intrinsic value remains. An out of the money option at expiry is worth exactly nothing, not a little, and the person who sold it to you keeps the whole premium.

In the money, at the money, out of the money

These three terms describe the relationship between the current share price and the strike, and the family name for the idea is moneyness. It drives an option’s premium, its risk and its chance of paying off.

Notice that the call and put columns are reversed, which is the single most common source of confusion for anyone new to a chain. The rule underneath is simple enough to reconstruct every time: an option is in the money when exercising it right now would be better than using the open market. For a call, that means the share is above your strike, since you would rather buy at the lower fixed price. For a put, it means the share is below your strike, since you would rather sell at the higher fixed price.

At the money options carry the most time value and tend to dominate trading volume, because they are the most sensitive to a move in the share and they serve both the hedgers and the speculators at once.

Expiry: the ticking clock

Every option has an expiry date, and an unexercised contract is worthless afterwards. That deadline is what makes time one of the most powerful forces in options pricing, and it is the thing that has no equivalent when you own shares.

• Weekly options expire each Friday. They are cheap, because there is little time left to pay for, but you must be right quickly and time decay is fierce in the final days.
• Monthly options expire on the third Friday of the month. They are the most liquid, and typically 30 to 60 days out they are the balanced choice for most strategies.
• LEAPS are long dated options expiring one to three years ahead. The premium is far higher and the decay far slower, which suits a longer term position.

The pattern to take from that list is that you are always buying time, and time has a price. A cheap option is usually cheap because it has almost none left, which makes it a harder bet rather than a better bargain.

American and European style: when may you act?

Every option is either American style or European style. Despite the names, this has nothing to do with where it trades. It refers only to when you may exercise.

American style is more flexible for the buyer, since you can act whenever you choose. That same flexibility is a risk for the seller, who can be assigned at any moment and must then deliver. European style is simpler to price and carries no early assignment, which is why index options are usually built that way.

Buyers and sellers: the asymmetry of risk

Every option trade has two sides, and this is the point at which most people realise that the two sides are not equivalent.

Read the bottom two rows together, because that pairing is the whole story. The buyer has a small, known loss and a large, unknown gain. The seller has a small, known gain and a large, unknown loss. Neither is better, and the seller is not being foolish, since the outcome that pays them is much more likely than the one that ruins them. But they are entirely different kinds of risk, and they demand different temperaments and different amounts of capital.

The seller’s exposure is at its most open ended when writing calls without owning the underlying shares, because delivering them would mean buying at whatever price the market demands. That is why selling options is treated as an advanced activity by every broker you will meet, and why module 6 explains that access to it is tiered.

Closing a position: sell before expiry

Most retail traders never exercise an option at all, which surprises people who assume exercising is the point of owning one.

Instead they sell the option itself before expiry, to bank a gain or cut a loss. Three reasons make this the normal route. Selling captures the intrinsic value and whatever time value is left, while exercising throws the time value away. It needs no share transaction, so you do not have to find the money to buy 100 shares in order to collect a profit on a contract. And it is usually simpler for tax.

That leaves a short rule for what to do with a position. Sell it while it still has value. Exercise only in the unusual cases where doing so is genuinely worth more than selling. And let it expire only when it is out of the money and worth nothing, at which point there is nothing to sell anyway.

A full trade, start to finish

Everything above now assembles into one complete trade.

That is a 90% return on the $200 at risk. Now compare it with the obvious alternative. Buying 100 shares outright would have cost $5,000, and selling at $56 would have made $600. That is a much larger cash profit and a return of only 12%.

The same view, expressed two ways, produced a bigger number and a smaller percentage on one side and the reverse on the other. That is leverage, and the honest way to state it is that leverage did not make the trade better. It made it smaller and sharper.

Which brings the necessary counterweight, and it is the last thing this module has to say. Had the share simply stayed at $50, the shareholder would have been flat, holding an asset with no deadline, free to wait for the next quarter. The option buyer would have lost the entire $200. Leverage does not only multiply the gain. It converts a disappointing outcome into a total one, and the reason the following six modules spend so much time on risk is that this asymmetry is present in every options trade you will ever place.