Investing in options is an advanced form of investing. Instead of purchasing shares of a company, an option is a contract that gives the buyer the right to buy or sell shares at a specific price before a set date. It's a timed investment, and unlike most investments, there's someone on the other side of your trade betting that you're wrong.
Instead of paying the share price, each option contract has a price called the premium, which is paid upfront from the buyer to the seller. The premium isn't fixed – it fluctuates based on market conditions and can be bought or sold before the contract expires. Like most contracts, there are agreed-upon terms and a date at which the contract expires.
The appeal is leverage: you can control a large position for a fraction of what it would cost to buy the shares outright. Each contract gives you the right to buy or sell 100 shares at a predetermined price, so when the underlying moves by a dollar, your potential payout moves by $100 – without having paid for 100 shares upfront.
The most prominent risk with options trading is that the position is on a timer. If the option doesn't move in the desired direction before the expiry date, it's possible that the entire investment – the premium – will be permanently lost.
Components of an option contract
Every option contract has four components: the option type, the underlying, the strike price, and the expiry date.
Option type: An option can either be a "call" option, which gives the buyer the right to purchase 100 shares of the underlying, or a "put" option, which gives the buyer the right to sell the same amount.
Underlying: The underlying is the security that the call or put option refers to. This underlying asset is often a stock or ETF. The option premium is influenced by the current market price of the underlying, among other factors.
Strike price: Each option contract has an agreed-upon price at which the shares can be bought or sold. This is determined before entering the trade and is an important factor in determining how expensive the option contract is. The strike price is what determines whether an option is "in the money" or "out of the money."
Expiry date: Option expiry dates vary widely, from as close as one day to as far as two years out. The shorter the expiry, the cheaper the option will be, because there is less time for the underlying price to move in the desired direction.
Pricing an option
An option premium is the price at which an option is trading. Like a stock price, it updates constantly based on market conditions. Unlike a stock price, which reflects the value of a company, an option's price is determined by two factors: intrinsic value and time value.
Intrinsic value is how much the option would be worth if you exercised it right now. For instance, if a put option gives the right to sell shares at $30, and the underlying is currently trading at $28, the option has at least $2 of intrinsic value, because it allows the holder to sell shares $2 above the current market price.
Time value reflects how much time remains until expiry. An option with a year until expiry will carry a much larger premium than one expiring in a week. It's a timed prediction: a longer expiry costs more, but gives the underlying more time to move in your favour.
When deciding to trade an option, toggle between different strike prices and expiration dates to see how each variable affects the premium.
In the money and out of the money
An option is either 'in the money' or 'out of the money,' meaning it either makes financial sense to exercise right now, or it doesn't.
For example, if you own a call option with the right to buy 100 shares at $50, and the underlying is currently trading at $60, the option is in the money. Buying at $50 when the market price is $60 makes financial sense.
When an option doesn't make financial sense to exercise, it's out of the money. As long as time remains before expiry, though, the price can still move in a favourable direction.
Option expiry
When an option reaches its expiry date out of the money, it expires worthless and is removed from the account. The premium paid is lost.
If an option is in the money at expiry, the holder has two choices: sell the option at its current market value, or exercise it to buy or sell the underlying shares at the agreed-upon strike price. Your brokerage will have a specific process for requesting an exercise.
Most option traders choose to sell their option rather than exercise it because exercising an option requires trading 100 shares of the underlying, which they may not be interested in or have the available funds to do. An option buyer does have the right at any time prior to expiry to exercise their option, but of the options that are exercised, most are exercised at expiry rather than before it.
The other side of an option contract
Options trade on exchanges, but there is always a counterparty on the other side of every contract. The buyer has the right to trade the security; the seller (also called the option writer) has the obligation to fulfill the contract if the buyer exercises it. This can be a costly position if the option moves deep in the money.
For example, say the option buyer has the right to purchase 100 shares at $20, and the stock climbs to $300. The option writer is on the hook to sell those shares at $20 regardless. If they don't already own them, they have to go buy 100 shares at $300 each just to fulfill the contract. That's a $28,000 loss ($280 x 100 shares).
Selling options is considerably riskier than buying them. The reason option writers accept that risk is the premium: they collect it upfront and profit if the option expires worthless. Longer expiry dates and more volatile underlying securities both command higher premiums, because the seller is taking on more risk.
An option seller's goal is for the option to expire worthless. Buyer and seller always want the opposite outcome – which is worth keeping in mind when you place a trade. Someone out there is betting against you.
Summary
An option contract is a leveraged investment that gives an investor exposure to 100 shares while only committing the cost of the premium. Because of that leverage, the premium can move more dramatically than the underlying price itself. The buyer gets the right to buy or sell 100 shares at a specified price before the expiry date. The core risk is that you need to be right twice: on direction, and on timing.
