Options: the Basics

TL;DR: An option is a contract that gives you the right to buy or sell a share (or another product) at a fixed price. Options use leverage and are complex. As a buyer you can lose at most the premium paid, but as a writer you can lose much more.

Step-by-step guide

1. Learn the terms: call, put, strike price, expiry date and premium.
2. Check whether your broker offers options and what it asks of you: often knowledge and experience with complex products.
3. Practise on a demo account and work through scenarios before you use real money.
4. Decide in advance your maximum loss and your expectation: direction, size and period.
5. If you want to start, start by buying options. Writing (selling) is much riskier.
6. Understand time value: an option loses value as expiry approaches.
7. Look at the costs: the premium, the spread and transaction fees.
8. Keep your position small and only use money you can afford to lose.

What is an option?

An option is a contract between two parties. The buyer pays an amount, the premium, and gets the right to buy or sell something at a price agreed in advance, the strike price. That right applies until a certain expiry date. The seller (writer) receives the premium, but has the obligation to deliver or take delivery if the buyer wants.

There are two kinds:

• Call: the right to buy. The buyer expects the price to rise.
• Put: the right to sell. The buyer expects the price to fall, or wants to protect a position.

A standard contract is often for 100 shares. Always check the contract size in the specifications of the exchange and your broker. You can find more about options as an asset class on our page about it.

Options in the EU

Options on shares and indices are traded on Euronext, among others. For private investors, options are complex products. In practice that means:

• Many brokers ask about your knowledge and experience and may restrict or refuse options if they think the product does not suit you.
• Options use leverage: a small stake moves with a much larger value. That can increase profit, but also loss.
• The risk is not the same for everyone. As a buyer you face a different risk than as a writer.

Writing options often requires collateral (margin). If prices move against you, you may have to add money.

Buying a call: worked example

Suppose share X is at €50. You buy a call with a strike price of €52 and a term of 3 months. The premium is €1.50 per share. For a contract of 100 shares you pay 1.50 × 100 = €150. This is a made-up example.

Profit or loss at expiry depends on X’s price:

• X is at €45, €50 or €52: the call is worthless. Your loss is the whole premium: €150.
• X is at €53: the call is worth €1 (53 - 52). Proceeds: €100, minus €150 paid = a €50 loss.
• X is at €53.50: break-even. That is the strike price plus the premium (52 + 1.50). Proceeds €150, cost €150.
• X is at €60: the call is worth €8 (60 - 52). Proceeds €800, minus €150 = €650 profit.

Comparison with buying shares

Instead of the call, you could buy 100 shares of X for €5,000. Then you get:

• At €60: profit €1,000 (+20% on €5,000).
• At €45: loss €500 (-10%).

With the call:

• At €60: profit €650 (+433% on €150).
• At €45: loss €150 (-100%).

The option needs a much smaller stake and gives a high percentage profit if the price rises a lot. But the option can also become completely worthless, while the share does not do that on a small fall. Leverage works both ways.

Buying a put: worked example

A put gives the right to sell. Suppose X is at €50 and you buy a put with a strike price of €48 for €1.20 per share. That is €120 per contract of 100 shares.

• X is at €50 or higher: the put is worthless. Loss €120.
• X is at €46.80: break-even (48 - 1.20).
• X is at €40: the put is worth €8 (48 - 40). Proceeds €800, minus €120 = €680 profit.

Puts are used to speculate on a fall, but also to protect an existing position against a price fall. This is called hedging. Also read about hedging.

What happens when you write options?

Someone who writes an option receives the premium immediately, but takes on an obligation. The risk is different from buying. The following examples show this.

Writing a put. You write a put with a strike price of €48 and receive €120. If X falls to €40, you must buy X for €48 while it is worth €40. Your loss is 8 × 100 - 120 = €680. If X falls to €30, your loss is 18 × 100 - 120 = €1,680. In the worst case, if X becomes worthless, the loss is 4,800 - 120 = €4,680. That is far more than the €120 you received.

Writing a call. You write a call with a strike price of €52 and receive €150. If X rises to €80, your loss is (80 - 52) × 100 - 150 = €2,650. In theory the price can rise without limit, so the loss can too. This applies especially if you do not own the shares.

So writing is not for beginners. The maximum profit is the premium received, while the loss can be a multiple. If you make a loss, your broker may ask you to add money or close your position.

What does an option’s price depend on?

The premium has two parts:

• Intrinsic value: what the option is already worth now. For a call with a strike of €52 and a price of €53, that is €1.
• Time value: what you pay extra for the chance that the price still moves favourably. In the example above, a call at a price of €53 might have a premium of €1.50: €1 intrinsic and €0.50 time value.

These are the main factors. The changes are often called ‘the Greeks’.

Delta: sensitivity to the price

Delta shows roughly how much the option changes when the share price moves €1. A delta of 0.50 means: the price rises €1, the option rises about €0.50 per share, or €50 per contract of 100 shares. Delta itself also changes as the price moves.

Theta: time decay

Time value disappears as expiry gets closer. A theta of -0.03 means the option loses about €0.03 per share per day, so €3 per contract, if everything else stays the same. This decay often speeds up just before expiry. So you lose value even if the price does not move.

Volatility: expected swings

If the market expects bigger swings, options become more expensive. Around company results or other news, the premium can be high. After the announcement it often falls quickly, even if the price moves the right way. So you can lose money while being right about the direction.

Common mistakes

• Buying an option far out of the money because the premium looks low. The chance that it pays off is small.
• Ignoring time decay. You need to be right not only about the direction, but also about the timing.
• Taking too large a position. An option can become completely worthless. Decide in advance how much you are willing to lose at most, for example with the position size calculator, and read more about risk management.
• Writing options without understanding the risk.
• Forgetting the costs. The spread between buy and sell price can be large for options, and you pay transaction fees per contract. See also balancing risk and reward.

Trading options involves great risk: you can lose your entire stake, and when writing options more than your stake. Past performance is no guarantee of future results. This tutorial is information, not investment advice.