What an options contract is — calls and puts

The answer

A call is the right to buy something at a fixed price before a fixed date. A put is the right to sell something at a fixed price before a fixed date. In both cases the buyer pays money at the start, called the premium, and that premium is gone whether or not the right is ever used.

Why this costs you money

Almost everybody meets options through the same sentence: your loss is limited to the premium.

That sentence is true and it is the most misleading true sentence in finance.

It is true because a bought option cannot lose more than what you paid. It is misleading because it does not mention the frequency. An option is a claim that expires. If the underlying does not move enough, in the right direction, before the expiry date, the option is worth exactly zero. Not a small loss. The whole amount.

Compare the 2 outcomes honestly.

• A share you bought at 100 that falls to 85 has lost 15%. You still own it. It can recover. There is no date by which it must.
• An out-of-the-money option you bought for Rs 40 that expires unexercised has lost 100%. Every time. There is nothing left to recover.

Now add the frequency. A large majority of out-of-the-money options expire worthless, because that is what out-of-the-money means: the underlying has not reached the price at which the right becomes useful. So the honest description of buying such an option is not "limited risk". It is a high chance of losing everything you put in, in exchange for a small chance of a large gain.

That is a legitimate structure. Insurance works this way, in reverse. But it is a completely different thing from what people hear when they are told the risk is limited.

Then there is the part almost nobody mentions. Every option's price contains a payment for time. The moment you buy, that payment starts draining away, every day, including days when the underlying does not move at all. You can be right about direction, right about magnitude, and still lose money because you were wrong about the date. No other instrument charges you rent for having an opinion.

How it works

Every option contract, anywhere in the world, is defined by exactly 4 things.

1. The underlying — the share, index or commodity the contract refers to.
2. The type — call or put.
3. The strike price — the fixed price at which the right may be exercised.
4. The expiry date — the last day the right exists.

A fifth number is not part of the contract's definition but decides whether you own it: the premium, which is what the option currently trades at.

Two people are always involved and their positions are not mirror images in shape, only in cash flow.

• The buyer, also called the holder, pays the premium and receives a right. The buyer may do nothing at all and simply let the option expire.
• The writer, also called the seller, receives the premium and takes on an obligation. If the buyer exercises, the writer must perform.

This asymmetry is the whole of options. One side has a choice. The other side has none, and is paid for that.

What a call does

You buy a call with a strike of 500, expiring in 1 month, for a premium of 20.

• If the underlying is at 560 at expiry, your right to buy at 500 is worth 60. You paid 20. You are ahead by 40.
• If the underlying is at 510, your right is worth 10. You paid 20. You lost 10.
• If the underlying is at 500 or below, the right to buy at 500 is worthless. Nobody exercises a right to pay more than the market price. You lost 20, all of it.

Your break-even is 520, not 500. The strike is where the option starts having value. The break-even is where you start having a profit. Beginners confuse the 2 constantly, and the gap between them is exactly the premium.

What a put does

You buy a put with a strike of 500, expiring in 1 month, for a premium of 20.

• If the underlying is at 440 at expiry, your right to sell at 500 is worth 60. You are ahead by 40.
• If the underlying is at 495, your right is worth 5. You lost 15.
• If the underlying is at 500 or above, the right to sell at 500 is worthless. You lost 20.

Your break-even is 480.

Where the premium comes from

An option's price has exactly 2 components, and separating them is the most useful skill in this cluster.

Intrinsic value is what the option is worth if it expired right now. For a call it is the underlying price minus the strike, and never less than zero. For a put it is the strike minus the underlying price, and never less than zero.

Time value is everything else. It is the market's payment for the possibility that things change before expiry.

Premium = intrinsic value + time value.

Time value depends on 3 things: how much time remains, how much the underlying is expected to move (its implied volatility), and how far the strike is from the current price. Time value only ever moves toward zero at expiry. That is guaranteed by the contract. Nothing else about an option is guaranteed.

Why options cost less than the shares

A call on 100 shares of a $50 company gives you exposure to $5,000 of stock and might cost $200. That is the appeal, and it is real.

It is also the trap, stated exactly. You have bought exposure to $5,000 of stock for $200, on the condition that the exposure disappears completely on a fixed date unless the stock moves enough by then. You did not buy the stock cheaply. You rented a temporary claim on the part of its move that exceeds your strike.

What it tells you, and what it does not

An option price tells you what the market charges today for a specific claim on a specific future. Read across a full option chain and you can infer what the market expects the range of outcomes to be. That is genuinely useful information and it is free.

An option price does not tell you what will happen. High premiums on a stock before results do not mean a big move is coming; they mean a big move is expected, and the price already contains that expectation. Buying the option does not get you the expected move. It gets you whatever the move is, minus what you paid for expecting it.

And the existence of a cheap option tells you nothing except that the market considers the outcome unlikely. Cheap is not the same as good value. In options, cheap usually means far away and soon.

The decision rule

Before buying any option, compute 3 numbers. All 3 take under a minute.

1. The break-even. Call: strike plus premium. Put: strike minus premium.

Then add all costs.

1. The required move, as a percentage. How far must the underlying travel

from where it is now to reach that break-even?

1. The days available. How many trading days remain until expiry?

Then ask the only question that matters: how often has this underlying moved that far, in that direction, in that many days? You can answer this from a chart in 2 minutes.

If the required move is larger than the underlying's normal movement over that period, you are not taking a position. You are paying a small amount for a small chance, on a deadline that is printed on the screen, and the honest way to size it is as money you expect to lose in full.

Try this now

Five minutes. This is the calculation that changes how most people look at an option chain, and it uses your own screen.

1. Open the option chain for any index or share you follow, for the current expiry. Note today's price of the underlying.
2. Pick a call whose strike is clearly above the current price — one that people would describe as cheap. Note its premium.
3. Compute the break-even: strike + premium.
4. Compute the required move: (break-even − current price) ÷ current price × 100. That is the percentage rise needed just to get your money back.
5. Count the calendar days to expiry.
6. Now open the chart of the underlying, set it to daily candles, and look at the last 12 months. Count how many times it moved that percentage, upward, within that many days.

What you should see. For a typical out-of-the-money weekly or monthly option, the required move is several percent and the number of historical occurrences is small. Many readers will count zero or 1 occurrence in a year.

That is the whole lesson, and it is arithmetic rather than opinion. You have just measured the probability the market was pricing, using the underlying's own history, and you did it without any model.

Now do the second half. Add your costs — brokerage, exchange charges, Securities Transaction Tax or its local equivalent, GST and stamp duty — and recompute the break-even. On a small premium, costs are a meaningful percentage, and they push the required move further.

If you hold an option right now, do this on that one instead of an example. It is more uncomfortable and it is more useful.

Three real cases

1. The Chicago Board Options Exchange opens, 26 April 1973 — the moment options became a market Before that day, options were private agreements with custom terms, no central clearing, and almost no ability to sell before expiry. The Cboe opened with listed call options on 16 companies and a clearing house standing between buyers and sellers. Put options were added in 1977. The invention that mattered was not the option. It was standardisation plus a clearing house, which is what turned a private promise into something you can sell to a stranger at 11:15 tomorrow. Everything in this cluster depends on that.

2. GameStop, January 2021 — what a call buyer actually owns Large numbers of individual traders bought short-dated call options on GameStop Corporation, alongside shares. The share price rose from under $20 at the start of January 2021 to an intraday high of about $483 on 28 January 2021. Some option buyers made extraordinary returns. Many others bought after the move, at premiums that had expanded to reflect the enormous volatility, and lost everything when the price fell back and the contracts expired. The instructive point is not the winners. It is that the same contract, on the same company, was a life-changing gain for somebody who bought on 12 January and a total loss for somebody who bought on 28 January. The difference was not analysis. It was the price paid for time and volatility.

3. Robinhood Financial, June 2020 and June 2021 — the display is not the position In June 2020 a 20-year-old customer named Alex Kearns died by suicide after apparently reading a very large negative number on his account screen relating to a multi-leg options position that had not finished settling. In June 2021 FINRA announced a settlement with Robinhood Financial requiring approximately $70 million in penalties and restitution, addressing, among other things, the approval of customers for options trading and the display of information relating to options positions. The lesson for any reader is direct and practical: an options position screen shows a snapshot of a contract, not your obligation. Before you place any options trade, know what the worst case is in cash, computed by you, on paper, independently of what any app displays.

The question that resolves it

A novice asks: which way will it move?

An expert asks: how far, by when, and is that further and sooner than this thing usually moves?

A view on direction is not enough to buy an option. An option requires a view on direction, magnitude and timing simultaneously, and each of the 3 can be wrong on its own.

What would make this wrong

If options were simply a leveraged way to express a view, then anybody with a better-than-average hit rate on direction would profit from buying them. Many people with good direction records lose money buying options, which tells you the instrument is not doing what they think.

Three honest limits.

Buying options is not always a bad idea. For a defined event with a known date — a court judgement, a regulatory decision, a scheduled announcement — a bought option is a clean way to take a position with a known maximum loss. The criticism in this article is of habitual buying of short-dated out-of-the-money options, not of the instrument.

"Most options expire worthless" is often stated wrongly. The commonly quoted figures conflate options that expire worthless with options that are closed before expiry, which is the majority of activity. The accurate statement is narrower: most out-of-the-money options held to expiry expire worthless, which follows from the definition.

Longer-dated options behave differently. An option with a year to run loses time value slowly and behaves much more like the underlying. Most of the harm described in this article is concentrated in very short-dated contracts, which is where retail volume is concentrated in both India and the United States.

Carry this

• A call is a right to buy. A put is a right to sell. Both expire.
• Break-even is strike plus premium for a call, strike minus premium for a put. Never the strike.
• Premium = intrinsic value + time value. Time value goes to zero. Always.
• Buying an option needs 3 correct judgements: direction, size of move, and date.
• In India, sell an in-the-money option rather than letting it be exercised, unless you have checked the tax arithmetic.

Knowledge check

Related

• Buying options compared with writing options: two completely different games
• In the money, at the money, out of the money
• Theta: why every option you own is quietly losing value
• What a derivative is
• ← Options and derivatives