Options explained simply: calls, puts, premiums and why they are risky
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Options come up constantly in trading forums, usually alongside screenshots of huge gains or painful losses. Before anyone touches them, it helps to understand what an option actually is, what you pay for it and why so many beginners are caught out. This guide is educational only and is not financial advice.
What an option is
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell something at a set price before or on a set date. The person on the other side, the seller or writer, takes on the obligation if the buyer chooses to use that right.
- Underlying: the share, index or fund the option is based on.
- Strike price: the price at which the buyer may buy or sell.
- Expiry: the date the contract ends. After it, an unused option is worthless.
- Premium: the price the buyer pays the seller for the contract.
On US exchanges, one standard equity option contract usually covers 100 shares, so the quoted premium is multiplied by 100. A premium shown as 2.20 therefore costs 220 dollars per contract, before fees.
Calls and puts
- A call gives the right to buy at the strike price. Buyers of calls profit if the underlying rises far enough above the strike to cover the premium paid.
- A put gives the right to sell at the strike price. Buyers of puts profit if the underlying falls far enough below the strike to cover the premium.
The phrase "far enough" is the part people forget. A share can move in the direction you expected and the option can still lose money, because the move was too small or came too late.
What makes up the premium
The premium has two parts.
- Intrinsic value: how much the option would be worth if exercised right now. A call with a strike below the current share price has some; one above it has none.
- Time value: what buyers pay for the chance that things change before expiry. It shrinks as expiry approaches, a process usually called time decay, and it tends to shrink faster in the final weeks.
Premiums also rise when the market expects big swings, known as implied volatility. After a widely anticipated event such as an earnings announcement, implied volatility often drops, and option prices can fall even when the share moves the way a buyer hoped.
Why options are risky
- Leverage cuts both ways. A small premium controls the price movement of many shares, so percentage gains and losses are large and fast.
- Buyers often lose the whole premium. If the option expires out of the money, it is worth nothing. Short-dated, far out-of-the-money options are cheap precisely because they usually expire worthless.
- Sellers can lose far more than they collect. Someone who writes a call without owning the shares, an uncovered or naked call, faces losses with no theoretical limit if the price keeps rising.
- Liquidity and spreads. Thinly traded options can have wide gaps between buying and selling prices, which costs you on every trade.
- Complexity. Multi-leg strategies, early assignment and exercise rules add ways to be surprised.
Many retail traders who buy short-term options lose money, and a few dramatic wins shared online say nothing about the losses nobody posts.
Before you go anywhere near them
- Read the risk disclosure document your broker provides; in the US this is the standard options disclosure booklet, and brokers must approve you for options trading.
- Learn with a paper trading account first.
- Never use money you need for bills, savings or debt repayments.
- Check your national regulator's investor pages, such as the FCA in the UK or the SEC and FINRA in the US, and confirm any firm you use is authorised.
This article explains concepts only and is not a recommendation to trade. If you are unsure, speak to a regulated, independent financial adviser.
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