Options, one step at a time.
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Basics · step 1 of 28
What is an option?
Want to lock in a price now and decide later? An lets you buy or sell a stock at a price you agree on today, for a limited time. You pay for that choice when you buy it, and you don’t have to use it.
If you use it, the seller has to go through with the deal. That’s called .
When you buy an option, someone sold it to you. You pay for a choice, and they take your money for a promise. You never have to use the choice. If you do, they have to keep the promise.
People use options for three main reasons.
- Protection. Buy options that pay off if your stocks fall, like insurance.
- A smaller bet. Act on a view about a stock for less than the shares cost. If you’re wrong, the option can expire worth nothing.
- Getting paid to take the other side. Sell the choice and collect the , like an insurer. If what you insured against happens, you pay out.
Think a stock will rise? A is the choice to buy it at an agreed price, even if the price climbs.
Think a stock will fall, or want to protect shares you own? A is the choice to sell at an agreed price, even if the price drops.
- The agreed price in the contract.
- The deadline. After it, the choice is gone.
- Premium
- The option’s price. It’s quoted per share and one covers 100 shares, so a $2.00 premium costs $200.
You can take either side of an option. Buying caps what you can lose at the price you paid. Selling pays you now and takes on the risk.
Own shares and worried about a drop? A put sets the lowest price you can sell them for until expiration. You pay the premium for that protection, like an insurance bill.
The most you can lose: the fall down to the strike price, plus the premium you paid.
Expect a rise? A call lets you benefit from it for less than buying the shares. If the stock doesn’t rise past the strike price by more than you paid, you lose some or all of the premium.
The most you can lose: the premium you paid.
This trips most people up at first. You aren’t selling shares; you’re selling a promise. You receive the premium right away, and if the buyer uses their choice, you have to buy or sell the shares at the agreed price. That’s called .
The most you can make is the premium. On its own, the loss can be many times larger.
The strategies on this page pair every option you sell with one you buy, which caps the loss. That pair is a .
When you buy an option, you can pay for two things. Part of the can be value it already has, because the agreed price is better than the stock’s price: . The rest pays for the time left and the chance of a bigger move: .
At expiration, the value of a is simple: how far the stock finished above the , or nothing.
At expiration, the value of a is simple too: how far the stock finished below the , or nothing.
Hold an option while the stock stands still, and it usually loses value as the gets closer. Less time left means less chance of a helpful move.
Two calls with the same strike price and deadline, on stocks at the same price, can still have very different prices. The difference is : how big the market expects the stock’s price swings to be. Bigger expected swings mean a higher price.
This is the trade the rest of the page follows. Sell one put, and buy another at a lower strike price to limit the loss. The difference between what you receive and what you pay is your , not your profit yet.
Before you act, pick three possible stock prices at expiration and see the same trade make money, , or lose money.
Widen the gap between the strike prices in a and you bring in a bigger credit, but you can also lose more.
Look at the , not just the credit. Both of these spreads can lose more at expiration than they can make.
The credit gives the stock room to fall before you lose money. The point where that room runs out is : no profit or loss at expiration, before fees.
You can win most of your trades and still barely make money. These made-up results on a practice balance show why each loss matters.
You’ve seen the pieces; here’s the whole trade. Two options collect a and cap the loss, and the stock’s price at expiration decides the profit or loss.
On its own, a sold put can lose far more than it brings in. Add a bought put at a lower strike price, on the same stock and expiration date, and the loss is capped. Together they make a .
The credit you receive when you open a trade is only the start. Subtract what you pay to it and the fees to find your profit or loss.
Each you add brings the same again: up to $150 more profit and up to $350 more loss.
An combines a put spread below the stock and a call spread above it. This example makes the most when the stock finishes between the strike prices of the two options you sold, and loses money only past its two break-even prices.
Where you place the options decides where the trade makes money. You sell options closer to the stock price and buy ones farther out to cap the loss.
There’s more inside.
This page shows a preview. The rest needs an account because it responds to you.
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Option
A contract that gives its buyer the choice to buy or sell 100 shares of a stock at an agreed price until a set date. The seller promises to honor that choice.
Derivative
Something whose value comes from something else. An option’s value comes from a stock’s price.
Contract
One option. A standard stock option covers 100 shares.
A $1.50 price means $150 for one contract.
Call
An option that gives its buyer the choice to buy shares at the strike price until expiration.
Put
An option that gives its buyer the choice to sell shares at the strike price until expiration.
Strike price
The agreed price written into the option: the price the shares change hands at if the choice is used.
Expiration date
The deadline. It’s the last day the choice can be used; after it, the option is gone.
Exercise
When the buyer uses their choice to actually buy or sell the shares.
In the money
An option that would be worth using right now: a call with the stock above its strike price, or a put with the stock below it. Otherwise it’s at or out of the money.
Stock at $102: a $100 call is in the money; a $100 put isn’t.
Automatic exercise
At expiration, brokers usually exercise an option that finishes at least $0.01 a share in the money, unless you tell them not to.
A $100 call with the stock at $101 at expiration becomes 100 shares bought for $10,000.
Assignment
When a seller must keep their promise and buy or sell the shares, because the buyer used their choice.
Early assignment
Assignment that happens before the expiration date.
Hedge
Something you buy to soften a loss on something else you own, like insurance.
Credit
The money left over when you open a trade that receives more than it pays: what you got for the option you sold, minus what you paid for the one you bought.
Receive $350, pay $200: a $150 credit.
Spread
Selling one option and buying another of the same type and expiration date, so one limits the other’s risk.
Credit spread
A spread that pays you a credit when you open it. The option you buy caps the most you can lose.
Collateral
Money your broker holds while a trade is open, to cover what it could lose. For a spread, that’s usually its maximum loss.
One $95/$100 put spread with a $150 credit: $350 held.
Iron condor
A put spread and a call spread opened together. It makes the most if the stock stays between them.
Volatility
How big the market expects the stock’s price swings to be. Bigger expected swings make options cost more.
Implied volatility
The size of the price swings, up or down, that an option’s price suggests the market expects.
Intrinsic value
The part of an option’s price you’d get by using it right now.
Stock at $102, strike price $100: $2 of intrinsic value per share.
Time value
The rest of an option’s price: what buyers pay for the time left and the chance of a bigger move.
Time decay
Time value shrinking as the expiration date gets closer.
Break-even
The stock price at expiration where the trade neither makes nor loses money, before fees.
Maximum loss
The most the trade can lose if held to the expiration date.
Spread width
The gap between the two strike prices, times 100 shares.
$5 × 100 = $500.
Close (a trade)
Making the opposite trade to end your position before the expiration date.
Defined risk
A trade whose largest possible loss is known before you open it.
Practice trading
Trading on real prices with pretend money, so mistakes cost nothing.
Brokerage account
An account at a broker, the company that holds your money and sends your trades to the market.
Broker
The company that holds your account and sends your orders to the market.
Clearing house
The organization that stands behind every listed option, so a buyer doesn’t depend on one seller keeping their word.
Quote
The price shown on screen for an option, usually per share.
Contract multiplier
The 100 that turns a per-share quote into dollars for one contract.
$1.50 × 100 = $150.
Bid and ask
The bid is roughly what you get when you sell right now. The ask is roughly what you pay when you buy right now.
Order
Your request to buy or sell at a price.
Fill
The moment your order actually trades.
Limit price
The worst price you’ll accept. If the market doesn’t reach it, nothing trades.
Working order
An order that has been sent but hasn’t filled or been canceled yet.
Position
What you currently hold: shares, options, or both.
Sell to open
Selling an option you don’t own, which creates your promise. Also called writing an option.
Sell to close
Selling an option you bought earlier, to exit it.
Unprotected (naked) sale
Selling an option with no shares, cash, or second option behind it. The loss can be very large.
Covered call
Selling a call on shares you already own.
Protective put
Buying a put to set a floor under shares you own.
Cash-secured put
Selling a put while keeping enough cash set aside to buy the shares if you’re assigned.
Expire worthless
An option that reaches its expiration date with nothing left to use simply disappears.
Backtest
Running your rules over past prices to see what would have happened. Past results don’t predict future ones.
Drawdown
The biggest drop from a high point before the balance recovered.
Entry conditions
The rules that decide when a strategy opens a trade.
Exit rule
A rule that decides when a strategy closes a trade.
Stop
An exit rule that closes a trade to cut a loss once it reaches a set size.
Ticker
The short code a stock trades under.
AAPL is Apple.