the term option refers to a financial instrument that is based on the value of underlying securities such as stocks indexes and exchange traded funds etfs an options contract offers the buyer the opportunity to buy or sell depending on the type of contract they hold the underlying asset unlike futures the holder is not required to buy or sell the asset if they decide against it 
each options contract will have a specific expiration date by which the holder must exercise their option the stated price on an option is known as the strike price options are typically bought and sold through online or retail brokers investopedia michela buttignolunderstanding optionsoptions are versatile financial products these contracts involve a buyer and seller where the buyer pays a premium for the rights granted by the contract call options allow the holder to buy the asset at a stated price within a specific time frame put options on the other hand allow the holder to sell the asset at a stated price within a specific time frame each call option has a bullish buyer and a bearish seller while put options have a bearish buyer and a bullish seller 1traders and investors buy and sell options for several reasons options speculation allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset investors use options to hedge or reduce the risk exposure of their portfolios in some cases the option holder can generate income when they buy call options or become an options writer options are also one of the most direct ways to invest in oil for options traders an option s daily trading volume and open interest are the two key numbers to watch to make the most well informed investment decisions american options can be exercised at any time before their expiration date while european options can only be exercised on the expiration date or the exercise date 2 exercising means utilizing the right to buy or sell the underlying security 1types of optionsa call option gives the holder the right but not the obligation to buy the underlying security at the strike price on or before expiration a call option will therefore become more valuable as the underlying security rises in price calls have a positive delta 3a long call can be used to speculate on the price of the underlying rising since it has unlimited upside potential but the maximum loss is the premium price paid for the option opposite to call options a put gives the holder the right but not the obligation to instead sell the underlying stock at the strike price on or before expiration a long put therefore is a short position in the underlying security since the put gains value as the underlying s price falls they have a negative delta 3 protective puts can be purchased as a sort of insurance providing a price floor for investors to hedge their positions american options can be exercised at any time between the date of purchase and the expiration date european options are different from american options in that they can only be exercised at the end of their lives on their expiration date the distinction between american and european options has nothing to do with geography only with early exercise many options on stock indexes are of the european type because the right to exercise early has some value an american option typically carries a higher premium than an otherwise identical european option this is because the early exercise feature is desirable and commands a premium in the u s most single stock options are american while index options are european 4special considerationsoptions contracts usually represent 100 shares of the underlying security the buyer pays a premium fee for each contract 1 for example if an option has a premium of 35 cents per contract buying one option costs 35 0 35 x 100 35 the premium is partially based on the strike price or the price for buying or selling the security until the expiration date another factor in the premium price is the expiration date just like with that carton of milk in the refrigerator the expiration date indicates the day the option contract must be used the underlying asset will influence the use by date and some options will expire daily weekly monthly and even quarterly for monthly contracts it is usually the third friday 54options spreads are strategies that use various combinations of buying and selling different options for the desired risk return profile spreads are constructed using vanilla options and can take advantage of various scenarios such as high or low volatility environments up or down moves or anything in between spread strategies can be characterized by their payoff or visualizations of their profit loss profile such as bull call spreads or iron condors options risk metrics the greeksthe options market uses the term the greeks to describe the different dimensions of risk involved in taking an options position either in a particular option or a portfolio these variables are called greeks because they are typically associated with greek symbols each risk variable is a result of an imperfect assumption or relationship of the option with another underlying variable traders use different greek values to assess options risk and manage option portfolios 6delta represents the rate of change between the option s price and a 1 change in the underlying asset s price in other words the price sensitivity of the option relative to the underlying delta of a call option has a range between zero and one while the delta of a put option has a range between zero and negative one for example assume an investor is long a call option with a delta of 0 50 therefore if the underlying stock increases by 1 the option s price would theoretically increase by 50 cents 3delta also represents the hedge ratio for creating a delta neutral position for options traders 7 so if you purchase a standard american call option with a 0 40 delta you need to sell 40 shares of stock to be fully hedged net delta for a portfolio of options can also be used to obtain the portfolio s hedge ratio a less common usage of an option s delta is the current probability that it will expire in the money for instance a 0 40 delta call option today has an implied 40 probability of finishing in the money 3theta represents the rate of change between the option price and time or time sensitivity sometimes known as an option s time decay theta indicates the amount an option s price would decrease as the time to expiration decreases all else equal for example assume an investor is long an option with a theta of 0 50 the option s price would decrease by 50 cents every day that passes all else being equal if three trading days pass the option s value would theoretically decrease by 1 50 theta increases when options are at the money and decreases when options are in and out of the money options closer to expiration also have accelerating time decay 8 long calls and long puts usually have negative theta short calls and short puts on the other hand have positive theta by comparison an instrument whose value is not eroded by time such as a stock has zero theta 9gamma represents the rate of change between an option s delta and the underlying asset s price this is called second order second derivative price sensitivity gamma indicates the amount the delta would change given a 1 move in the underlying security let s assume an investor is long one call option on hypothetical stock xyz the call option has a delta of 0 50 and a gamma of 0 10 therefore if stock xyz increases or decreases by 1 the call option s delta would increase or decrease by 0 10 gamma is used to determine the stability of an option s delta higher gamma values indicate that delta could change dramatically in response to even small movements in the underlying s price gamma is higher for options that are at the money and lower for options that are in and out of the money and accelerates in magnitude as expiration approaches gamma values are generally smaller the further away from the date of expiration this means that options with longer expirations are less sensitive to delta changes as expiration approaches gamma values are typically larger as price changes have more impact on gamma 10options traders may opt to not only hedge delta but also gamma in order to be delta gamma neutral meaning that as the underlying price moves the delta will remain close to zero 11vega v represents the rate of change between an option s value and the underlying asset s implied volatility this is the option s sensitivity to volatility vega indicates the amount an option s price changes given a 1 change in implied volatility for example an option with a vega of 0 10 indicates the option s value is expected to change by 10 cents if the implied volatility changes by 1 because increased volatility implies that the underlying instrument is more likely to experience extreme values a rise in volatility correspondingly increases the value of an option conversely a decrease in volatility negatively affects the value of the option 12 vega is at its maximum for at the money options that have longer times until expiration 13those familiar with the greek language will point out that there is no actual greek letter named vega there are various theories about how this symbol which resembles the greek letter nu found its way into stock trading lingo rho p represents the rate of change between an option s value and a 1 change in the interest rate this measures sensitivity to the interest rate for example assume a call option has a rho of 0 05 and a price of 1 25 if interest rates rise by 1 the value of the call option would increase to 1 30 all else being equal the opposite is true for put options rho is greatest for at the money options with long times until expiration 14some other greeks which aren t discussed as often are lambda epsilon vomma vera speed zomma color ultima these greeks are second or third derivatives of the pricing model and affect things like the change in delta with a change in volatility they are increasingly used in options trading strategies as computer software can quickly compute and account for these complex and sometimes esoteric risk factors advantages and disadvantages of optionsas mentioned earlier call options allow the holder to buy an underlying security at the stated strike price by the expiration date called the expiry the holder has no obligation to buy the asset if they do not want to purchase the asset the risk to the buyer is limited to the premium paid fluctuations of the underlying stock have no impact buyers are bullish on a stock and believe the share price will rise above the strike price before the option expires if the investor s bullish outlook is realized and the price increases above the strike price the investor can exercise the option buy the stock at the strike price and immediately sell the stock at the current market price for a profit their profit on this trade is the market share price less the strike share price plus the expense of the option the premium and any brokerage commission to place the orders the result is multiplied by the number of option contracts purchased then multiplied by 100 assuming each contract represents 100 shares if the underlying stock price does not move above the strike price by the expiration date the option expires worthlessly the holder is not required to buy the shares but will lose the premium paid for the call 15selling call options is known as writing a contract the writer receives the premium fee in other words a buyer pays the premium to the writer or seller of an option the maximum profit is the premium received when selling the option an investor who sells a call option is bearish and believes the underlying stock s price will fall or remain relatively close to the option s strike price during the life of the option if the prevailing market share price is at or below the strike price by expiry the option expires worthlessly for the call buyer the option seller pockets the premium as their profit the option is not exercised because the buyer would not buy the stock at the strike price higher than or equal to the prevailing market price however if the market share price is more than the strike price at expiry the seller of the option must sell the shares to an option buyer at that lower strike price in other words the seller must either sell shares from their portfolio holdings or buy the stock at the prevailing market price to sell to the call option buyer the contract writer incurs a loss how large of a loss depends on the cost basis of the shares they must use to cover the option order plus any brokerage order expenses but less any premium they received as you can see the risk to the call writers is far greater than the risk exposure of call buyers the call buyer only loses the premium the writer faces infinite risk because the stock price could continue to rise increasing losses significantly 15put options are investments where the buyer believes the underlying stock s market price will fall below the strike price on or before the expiration date of the option once again the holder can sell shares without the obligation to sell at the stated strike per share price by the stated date since buyers of put options want the stock price to decrease the put option is profitable when the underlying stock s price is below the strike price if the prevailing market price is less than the strike price at expiry the investor can exercise the put they will sell shares at the option s higher strike price should they wish to replace their holding of these shares they may buy them on the open market their profit on this trade is the strike price less the current market price plus expenses the premium and any brokerage commission to place the orders the result would be multiplied by the number of option contracts purchased then multiplied by 100 assuming each contract represents 100 shares the value of holding a put option will increase as the underlying stock price decreases conversely the value of the put option declines as the stock price increases the risk of buying put options is limited to the loss of the premium if the option expires worthlessly 15selling put options is also known as writing a contract a put option writer believes the underlying stock s price will stay the same or increase over the life of the option making them bullish on the shares here the option buyer has the right to make the seller buy shares of the underlying asset at the strike price on expiry if the underlying stock s price closes above the strike price by the expiration date the put option expires worthlessly the writer s maximum profit is the premium the option isn t exercised because the option buyer would not sell the stock at the lower strike share price when the market price is more if the stock s market value falls below the option strike price the writer is obligated to buy shares of the underlying stock at the strike price in other words the put option will be exercised by the option buyer who sells their shares at the strike price as it is higher than the stock s market value the risk for the put option writer happens when the market s price falls below the strike price the seller is forced to purchase shares at the strike price at expiration the writer s loss can be significant depending on how much the shares depreciate 15the writer or seller can either hold on to the shares and hope the stock price rises back above the purchase price or sell the shares and take the loss any loss is offset by the premium received an investor may write put options at a strike price where they see the shares being a good value and would be willing to buy at that price when the price falls and the buyer exercises their option they get the stock at the price they want with the added benefit of receiving the option premium a call option buyer has the right to buy assets at a lower price than the market when the stock s price risesthe put option buyer profits by selling stock at the strike price when the market price is below the strike priceoption sellers receive a premium fee from the buyer for writing an optionthe put option seller may have to buy the asset at the higher strike price than they would normally pay if the market fallsthe call option writer faces infinite risk if the stock s price rises and are forced to buy shares at a high priceoption buyers must pay an upfront premium to the writers of the optionexample of an optionsuppose that microsoft mfst shares trade at 108 per share and you believe they will increase in value you decide to buy a call option to benefit from an increase in the stock s price you purchase one call option with a strike price of 115 for one month in the future for 37 cents per contract your total cash outlay is 37 for the position plus fees and commissions 0 37 x 100 37 if the stock rises to 116 your option will be worth 1 since you could exercise the option to acquire the stock for 115 per share and immediately resell it for 116 per share the profit on the option position would be 170 3 since you paid 37 cents and earned 1 that s much higher than the 7 4 increase in the underlying stock price from 108 to 116 at the time of expiry in other words the profit in dollar terms would be a net of 63 cents or 63 since one option contract represents 100 shares 1 0 37 x 100 63 if the stock fell to 100 your option would expire worthlessly and you would be out 37 premium the upside is that you didn t buy 100 shares at 108 which would have resulted in an 8 per share or 800 total loss as you can see options can help limit your downside risk options trading involves a lot of lingo here are just some of the key terminology to know the meanings of 