What are Options?

Investing isn’t just about buying and selling stocks or bonds—there’s a whole world of financial instruments out there designed to fit various goals and strategies. One such instrument is an option, a type of derivative that gives investors flexibility, leverage, and risk management opportunities.

An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset (like a stock, bond, or commodity) at a predetermined price, known as the strike price, before or on a specified date.

Key Features of Options

  • Underlying Asset

    The asset the option is based on (e.g., stock or index).

  • Strike Price

    The price at which the option can be exercised.

  • Expiration Date

    The last date the option can be exercised.

  • Premium

    The cost of purchasing the option, paid upfront by the buyer.

Types of Options

These are 2 main types of options:

  • Call Options give the buyer the right to buy the underlying asset at the strike price. Investors use call options when they believe the asset's price will rise. A call option is like reserving the right to buy a concert ticket at a specific price. If the ticket price goes up, your reservation (option) is valuable.

  • Put Options give the buyer the right to sell the underlying asset at the strike price. Investors use put options when they think the asset's price will fall. A put option is like reserving the right to sell your car at a specific price. If car prices drop, your reservation to sell at the higher price is valuable.

  • Options are also categorized as European or American, based on the rules that govern them.

Who Sells Options on Stocks?

Options on stocks are not sold by the companies themselves*. Instead, they are created and traded through intermediaries in financial markets, such as options exchanges (you might have heard about the "stock exchange", this is the "options exchange").

Market participants, including retail traders, institutional investors, and market makers, can sell (or "write") options contracts. When someone writes an option, they take on the obligation to fulfill the contract terms if the buyer decides to exercise it.

To ensure smooth and transparent trading, clearinghouses like the Options Clearing Corporation (OCC) standardize, regulate, and guarantee the settlement of these contracts.

*Companies themselves only issue stock options privately to employees as part of compensation packages, but these are separate from the tradable options available in public markets.

Examples

Let's take a look at these Call and Put Scenarios.

Scenario 1: Call Option

You buy a call option for a stock priced at $50, with a strike price of $55 and a premium of $2.

If the stock price rises to $60, you can exercise your option to buy it at $55, selling it at $60 for a profit.

Profit : \[(60−55)−2 = 3(60−55)−2 = 3\]

You earn $3 per each share.


Scenario 2: Put Option

You buy a put option for a stock priced at $100, with a strike price of $95 and a premium of $3.

If the stock price falls to $90, you can sell it at $95, securing a profit.

Profit:
\[(95−90)−3 = 2(95−90)−3 = 2\]

You earn $2 per each share.

Where Do Stocks Come From When You Exercise a Call Option?

When you exercise a call option to buy a company’s stock, the shares are not newly issued by the company. Instead, the stock is sourced from the secondary market, where existing shares are traded between investors. 

The option writer (the person who sold the call option) is responsible for delivering the shares to you. If the option writer already owns the shares, they are directly transferred to you (covered call). If not, the writer buys the shares from the market at the current price (naked call) to fulfill their obligation. 

The OCC or a similar clearinghouse facilitates this process by ensuring that the transaction is completed seamlessly. This system ensures liquidity and allows options trading to operate independently of the company’s direct involvement.

Why Do Investors Use Options?

  • Hedging Risk

    Options can protect against potential losses in other investments. For example, buying a put option on a stock you own can act as insurance if the stock price drops.

  • Speculation

    Traders can use options to bet on price movements without owning the underlying asset.

  • Leverage

    Options allow you to control a large amount of the underlying asset with a smaller investment, amplifying potential gains (and losses).

FAQ

  • What happens when an option expires?

    If you don’t exercise an option before it expires, it becomes worthless, and you lose the premium paid.

  • How is an option different from a stock?

    Stocks represent ownership in a company, while options are contracts that derive their value from an underlying asset without conferring ownership.

  • Do I have to exercise an option?

    No, options give you the right, but not the obligation, to exercise them. If it’s not profitable to do so, you can let the option expire.

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