Option

What an option means

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a fixed price, called the strike price, on or before a set expiry date. The underlying can be a share, an index, an ETF, a currency pair, a commodity or a futures contract. The seller of the option, known as the writer, takes on the obligation to deliver if the buyer exercises.

There are two basic types. A call option gives the right to buy, and a put option gives the right to sell. The buyer pays an upfront price for this right, called the premium, which is the most the buyer can lose. The seller receives the premium and carries the obligation.

Options are used for hedging existing holdings, for generating income, and for taking a view on direction or volatility with a smaller upfront outlay than buying the underlying. They are also complex, and many brokers require extra approval and a knowledge check before offering them to retail clients.

How it works

An option's price has two parts. Intrinsic value is the amount by which the option is already in the money: for a call, the underlying price minus the strike if that is positive; for a put, the strike minus the underlying price if positive. Time value is everything above that, reflecting the chance that the option gains value before expiry.

Several factors influence the premium:

1. The underlying price relative to the strike.
2. Time left to expiry; time value erodes as expiry approaches.
3. Implied volatility, the market's estimate of future price swings.
4. Interest rates and expected dividends, which have smaller effects.

Contracts are standardised on exchanges, with a set number of units each, commonly 100 shares for US equity options. Styles differ: American options can be exercised any time before expiry, European options only at expiry. Many index options settle in cash rather than in the asset.

At expiry, an in-the-money option is typically exercised or settled automatically, and an out-of-the-money option expires worthless. Before expiry, holders may sell the option back to the market to close the position.

A worked example

The figures are illustrative. A share trades at 100. A trader buys one call option with a strike of 105, expiring in two months, for a premium of 2.50 per share. One contract covers 100 shares.

• Cost = 2.50 x 100 = 250. This is the maximum loss.
• Break-even at expiry = strike + premium = 105 + 2.50 = 107.50.

Scenario A: At expiry the share is at 115. The option is worth 115 - 105 = 10 per share, or 1,000 per contract. Profit = 1,000 - 250 = 750 before fees.

Scenario B: At expiry the share is at 104. The option has no intrinsic value and expires worthless. Loss = 250, the full premium.

The seller of this call collected 250. If the share had reached 115, the seller would face a loss of 750 net of premium, and if the seller had no hedge, the potential loss on an uncovered call has no upper limit.

Why it matters

Options allow precise shaping of risk. A buyer can limit loss to the premium while keeping exposure to a move, and an investor holding shares can use puts as insurance against a fall. Because of leverage built into the contract, a small move in the underlying can change the option value by a large percentage, in either direction.

Options also introduce factors that shares do not have: time decay, volatility changes and expiry. They can lose value even if the underlying moves in the expected direction, if the move is too small or too slow.

Costs differ across brokers, including per-contract commissions, exercise and assignment fees, and spreads, which can be wide in less liquid contracts.

How to use it in practice

1. Learn the basics of calls and puts on a demo account or with paper trading before using real money.
2. Check the strike, expiry, contract size and whether it is American or European style.
3. Look at the bid-ask spread and open interest to judge liquidity.
4. Calculate break-even and maximum loss before placing the trade.
5. Understand what happens at expiry, including assignment and settlement.
6. Read the broker's options approval levels and fee schedule.

Common mistakes and misconceptions

• Believing options are just cheap shares. Time decay and expiry can erase value.
• Buying far out-of-the-money options because they are cheap. They often expire worthless.
• Selling uncovered options without understanding unlimited or very large risk.
• Ignoring implied volatility, which can fall after events and cut the premium.
• Forgetting early assignment risk on American-style options you have sold.
• Holding through expiry without a plan for exercise or settlement.

Risks and limitations

Buyers can lose the entire premium, and sellers can face large losses, potentially far beyond the premium received. Options can be illiquid, and pricing models rely on assumptions. Tax treatment and rules for retail access vary by country. Options are not suitable for everyone, and the possibility of rapid loss is high.

How Brokeli looks at it

When we review brokers we check whether options are offered, which markets and approval levels apply, and what per-contract fees and margin rules exist. Data comes from published research snapshots and fee schedules for the relevant entity. We describe how options work and what they cost, without recommending any strategy.