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What is an Option?

Jack and Nick Author Pic
Jack Kramer & Nick MartellAugust 27, 2019
Forbes 30 Under 30 in media, appeared on CBS, Cheddar. Registered representatives of Robinhood Financial LLC.
definition

An option gives the owner the right to buy or sell a certain security, at a certain price, up until a certain expiration date.

“Long call”: Options are complex. This chart shows a theoretical call option with an exercise price of $5 and a premium cost of $2 and how its payoff to the owner changes in three different scenarios. As discussed in this article, option value = stock price - strike price. The buyer’s gain or loss = Option value - premium. This is just an illustration of a theoretical option contract, not the return of any actual option contract.

🤔 Understanding an option

An option is a contract that gives the owner the right — but not the obligation — to do something. It’s a “derivative,” which in finance is something whose value is dependent on the value of something else. An option’s value is dependent on the price of the underlying security it’s linked to, like a stock. An options contract allows the owner to buy (in the case of a “call”) or sell (in the case of a “put”) 100 shares of the underlying asset. It only makes sense to exercise the option if the price of the underlying stock is on the right side of the strike price, aka if the option is “in the money.” If you own a valuable option, you may be able to exercise it, or sell the same option you bought to another investor (aka closing your position), for a gain. Options often expire with no value, so you should understand the risk before investing.

example

On July 15, 2019, Uber’s stock was trading at $44. If you’re bullish on Uber and think the stock will rise, you could have bought a call with an exercise price of $48 that expires Jan 17, 2020 (that was available on the Robinhood investing app on that day). That option cost $3.40, and since it gives you the right to buy 100 shares of Uber for $48 any time before January 17, 2020, it cost $340 (plus fees and commissions). That premium is your cost, and you hope that Uber’s price rises above $48. If it does, you could make a gain. If the price increases to $55 (for example), you could exercise the option, buying 100 shares for $48 each even though they’re worth $55 (you’d make some money!). If the stock stays below $48 through the expiration, that option won’t have any value for you and you’ll lose the $340.

Takeaway

An option is like an umbrella... It could be valuable for you, or it could end up having no value at all. The beauty with an option, and with an umbrella, is that you don’t have to use it. You bought it, now it’s your option whether to exercise it or not. You use the umbrella when it rains. You exercise the option if it’s in the money. Options expire though, umbrella’s don’t (no analogy is perfect).

Options Illustration

Tell me more...

How does an option work?
The “call” option and the “put” option
In the money, at the money, out of the money
How much value does an option have?
What the owner of the option can do?
Long vs. short, bullish vs. bearish
Risks of investing with options
How can I buy an option?
What are the uses of options?

How does an option work?

An option is actually a legally-binding contract – it ties the buyer and the seller of the option to do certain things. The buyer gets the right to buy or sell, per the option contract, and since there’s value for that, she pays the seller a premium. The seller has made a promise to buy or sell the stock at a certain price, until a certain expiration date, if the buyer exercises it.

Here’s some vocab you should know.

  • Premium: The buyer of the option pays the seller a premium, which is the price of the option. It’s often quoted as the price per contract, but since most options contracts represent 100 shares of the underlying security, you’ll usually pay 100 times the premium for one option contract.
  • Strike price — aka "exercise price." This is the price the seller promises to buy or sell at anytime through the expiration date.
  • Expiration date: The contract is valid through the expiration date. After that, the seller has fulfilled his obligation, and the deal is done. An option has no value after the expiration date. For stock options, the expiration date is usually the third Friday of the contract’s end month.

Options Scroll

The “call” option and the “put” option

There are two types of options: a call and a put.

  • The owner of a call has the right to buy a certain asset at a certain strike price until a certain expiration date.
  • The owner of a put has the right to sell a certain asset at a certain strike price until a certain expiration date.

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

If you have a coupon to buy a Big Mac for $20, that’s pretty much a worthless coupon — you’ll just throw away the coupon and buy a Big Mac for the normal price (which is less than $20, last time we checked).

Options are like coupons in the sense that you don’t need to use them, but you can if it makes sense based on the price of the underlying thing (like the Big Mac, or a stock). Whether an option has value depends on what the underlying asset price is compared to the strike price.

Options can be in the money, at the money, or out of the money.

  • In the money: When an option’s strike price is below the underlying asset price for a call, or above the underlying asset price for a put. When an option is in the money, an investor has an incentive to exercise the option, because he can buy or sell the asset at a better price (buying it at a lower price, or selling it at a higher price). When an option is at the money, the investor would get the same price if he bought or sold the asset on the open market as if he exercised the option.
  • At the money: When an option’s strike price is equal to the underlying asset price.
  • Out of the money: When an option’s strike price is above the underlying asset price for a call, or below the underlying asset price for a put. When an option is out of the money, the investor would get a worse price by exercising the option, so it’s better to buy or sell the stock in the open market instead. Out of the money options have less, or no, value.

For a call, the value of the option generally increases as the price of the underlying asset increases.

For a put, the value of the option generally increases as the price of the underlying asset decreases.

How much value does an option have?

An option’s value is reflected by its price, known in the business as the “premium.” As a retail investor, you just see the price of the option as a number shown on your brokerage platform. But it really has two chunks:

Intrinsic value + Time value = Price of option

  • Intrinsic value: This is the amount by which an option is in the money. For options that are out of the money or at the money, the intrinsic value is zero. But for in the money options, there is intrinsic value because the investor could gain by exercising it.
  • Time value: This is the part of the price of the option that reflects the time remaining before expiration. The longer away the expiration date is, the more time the option has to get into the money. For that reason, longer-date options have more time value than shorter-date options. And the more volatile a stock is, the more time value the options for that stock should have, because more volatility makes it more likely the option could swing into the money.

Ultimately, options may be valuable for the likelihood that they become in the money. If they’re in the money already, they have intrinsic value. Time value exists because more time increases the chance that the underlying asset price moves and makes the option become in the money.

And the value of an option is reflected by its premium price.

What the owner of the option can do?

The owner of an option has the right to exercise the contract, let it expire worthless, or sell it back into the market before the expiration. The owner of the contract is likely to exercise the contract if it’s “in the money.” On the other hand, the seller of an option contract who collected a premium has the obligation to buy or sell if the option owner exercises it.

If you own an option, there are three things you can do:

  • Sell it prior to the expiration date: Options have value that change day to day, driven by the underlying stock price. The value is reflected in the premium, and you can make an order to sell your option prior to its expiration. The difference between how much you paid for the option and how much you’re selling it for is your gain or your loss.
  • Exercise it prior to the expiration date: American style options can be exercised any time before the expiration date, while European style options can only be exercised on the expiration date.
  • Let it expire, and it automatically exercises: Your brokerage firm may have a policy of exercising options for you if they are in the money and they expire. Check your brokerage firm’s specific policies and procedures.
  • Let it expire with no value: If your option expires and is out of the money, then it becomes worthless, and your investment is over.

Long vs. short, bullish vs. bearish

There are two key investing options using options for investors who are bearish, and for investors who are bullish.

If you’re bullish, you think a stock price will go up. To act on the optimism, you could buy a stock, or you could invest in options. Here are two bullish options strategies:

  • If you think a stock may rise, you can buy a call. The value of a call increases as the price of the underlying stock rises. If you were wrong, and the stock falls or stays the same, the option could expire worthless, and you just lose the premium you paid.
  • You could also sell a put. Since you think the stock will rise, you could earn a premium by selling a put to another investor. If the price rises, the put you sold will expire worthless, and you walk away with the premium as your gain. If you were wrong, and the price of the stock falls, you could be obligated to buy the stock from the option owner of the put at a price that could cause a loss for you. The potential loss of selling a put is the entire price of the stock minus the premium received, so be careful.

If you’re bearish, you think a stock price will go down. To make an investment based off of your pessimism about a company’s prospects, you could short a stock, or you could invest in options.

  • If you think a stock may fall, you can buy a put. The value of a put increases as the price of the underlying stock falls. If you were wrong, and the stock rises or stays the same, the option could expire worthless, and you just lose the premium you paid.
  • You could also sell a call. Since you think the stock will fall, you could earn a premium by selling a call to another investor. If the price falls, the call you sold will expire worthless, and you walk away with the premium as your gain. If you were wrong, and the price of the stock rises, you could be obligated to sell the stock to the owner of the call at a price that could cause a loss for you. The potential loss of selling a call is unlimited, so be careful.

Risks of investing with options

When it comes to options, you can be the buyer or the seller.

As the buyer of an option, your risk is limited to just the premium that you paid. The worst case is that the option expires out of the money, worthless, and you lose the entire amount you paid for the option. The best case is that the option moves into the money and you make a gain that makes up for the premium you paid.

As the seller of an option, your risk is more open-ended. If you sell a contract, you’re hoping that it never gets exercised. In that case, your gain is the amount of the premium. If it does get exercised, you could be on the hook to buy or sell a stock at a money-losing price.

  • If you sell a call, for example, your potential loss is unlimited, as the underlying stock price could increase infinitely high. If the stock rises very high, you are obligated to sell the stock to the buyer of the option at the exercise price. Although you made some money (the premium) by selling the option, you could lose a lot more by having to sell the stock to the option buyer at an exercise price that’s much less than the market value.
  • If you sell a put, your potential loss is limited to the cost of 100 shares of the underlying asset. That’s because the stock price could go to zero, but as the seller of a put you’re obligated to buy stock from the put owner at the strike price. The difference between the stock price and the strike price is your loss (which will be offset partially by the premium you collected at the beginning).

It’s important to understand that as the seller of an option, your risk is potentially unlimited. As a buyer, your risk is that your option expires with no value, and you lose the entire premium you paid with nothing to show for it.

Options transactions may involve a high degree of risk. Please review the options disclosure document titled Characteristics and Risks of Standardized Options available here to learn more about the risks associated with options trading.

How can I buy an option?

Options are available to retail investors through brokerage companies, like Robinhood.

You buy an option for a premium. The cost to you is the premium (remember that premiums are often quoted as a per-share price, but are sold in contracts of 100 shares. So a $0.30 premium would cost $30, since it’s good for the right to buy or sell 100 shares of the underlying asset) plus any commissions and fees your brokerage charges. Note: Robinhood does not charge commissions (Other relevant SEC and FINRA or other fees may still apply. Please see Robinhood’s Commission & Fee Schedule here) .

What are the uses of options?

  • To help protect downside risk (aka to “hedge”): If you buy a stock, you think the price will rise. You could be wrong though. To protect yourself from loss if the stock price falls, you could buy a put. The premium you pay is effectively insurance that limits the loss on your investment. That’s because once the price of the stock falls below the exercise price of the put, then the value of the stock and the value of the put will offset each other, given that the put applies to the same number of shares as the amount of stock you own.
  • To generate income: You could sell options to generate extra income. The premiums you earn are income. But there’s a big risk - if your options are exercised by the owner, you face potentially unlimited losses.
  • To speculate: You may want to invest in a stock rising or falling. Instead of buying the stock or selling it short, you could buy a call or buy a put. That has a smaller upfront cost, but offers a similar investment strategy.

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This information is provided for educational purposes only and is not and should not be construed as an offer to sell or a solicitation of an offer to buy any security. In addition, this information is not intended to serve as a recommendation to buy or sell any security or other investment product. This information is not individualized, does not constitute a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security, or financial product does not guarantee future results or returns. Before making decisions with legal, tax, or accounting ramifications, you should consult appropriate professionals and/or an investment adviser for advice that is specific to your situation. Securities offered through Robinhood Financial LLC, member SIPC and FINRA. The information used to create this content is based upon information reasonably available to Robinhood Financial LLC as of the date of publication. © 2019 Robinhood Markets, Inc. Robinhood® is a trademark of Robinhood Markets, Inc.