Option
What is Option?
An option gives its buyer a right, but not an obligation, to buy, sell, or otherwise receive a specified payoff under defined terms, while the seller assumes the corresponding obligation.
Option ownership is a package of contingent rights and sensitivities rather than a simple directional bet. Investors should separate expiration payoff from mark-to-market behavior, model the interaction of price, volatility, and time, and consider assignment and funding. Suitability depends on the complete strategy, portfolio context, contract specification, trading capacity, and ability to withstand a total premium loss or larger written-option obligation.
Core option terms
A contract identifies underlying, call or put type, strike, expiration, exercise style, multiplier, settlement, and deliverable. American-style options may generally be exercised before expiration, while European-style options generally exercise only at expiration, subject to exact rules. Corporate actions can adjust listed contracts, so the current deliverable can differ from the standard share amount.
Buyer and seller economics
The buyer pays premium and usually has loss limited to that premium, absent financing or exercise effects. The writer receives premium but can face substantial or theoretically unlimited loss depending on the position. Covered does not mean riskless, and margin is collateral rather than maximum loss. Portfolio combinations can transform both payoff and risk.
Example
A call with $50 strike costs $3. At expiration with stock at $58, intrinsic value is $8 and profit before costs is $5. At $49, it expires worthless and the buyer loses $3. The writer has the opposite contractual result. Before expiration, time value and implied volatility also influence price.
Valuation and use
Option value reflects underlying price, strike, time, volatility, rates, dividends, exercise, and model assumptions. Options can hedge downside, cap prices, express views, or create income-like cash flows, but payoff must be evaluated at portfolio level. Greeks summarize local sensitivities and can change rapidly, especially near expiration or the strike.
Risks and practical checklist
Options face leverage, time decay, volatility, liquidity, assignment, exercise, gap, model, and counterparty risk. Confirm contract symbol, multiplier, expiration time, style, settlement, deliverable, and automatic-exercise rules. Model profit and loss across prices, volatility, and time, including commissions and spread. Do not sell an option merely because most contracts expire worthless or assume premium received is earned income before expiration.
Sources and further reading
- Investor Bulletin: An Introduction to Options, Investor.gov, U.S. Securities and Exchange Commission
- CFTC Glossary, U.S. Commodity Futures Trading Commission