What Is an Option?
What you'll learn in this module
- Define an option as a contract with a right, not an obligation, for the buyer
- Explain that one standard equity option contract covers 100 shares
- Describe the roles of the buyer (holder) and the seller (writer)
Lesson
An option is a contract. It gives the buyer the right, but not the obligation, to buy or sell something at a set price before or on a set date. That "something" is called the underlying. In this course, the underlying is usually a stock or an ETF like SPY.
Every option has two sides:
- The buyer (holder) pays money up front. That payment is called the premium. In return, the buyer gets a right they can use or ignore.
- The seller (writer) receives the premium. In return, the seller takes on an obligation. If the buyer uses the right, the seller must follow through.
Using the right is called exercising the option. When a buyer exercises, a seller gets assigned.
One contract = 100 shares. A standard U.S. equity or ETF option controls 100 shares of the underlying. Option prices are quoted per share. So a premium of $2.00 really costs $2.00 x 100 = $200 per contract. This multiplier trips up a lot of beginners. Always multiply by 100.
American-style vs. European-style. Most U.S. stock and ETF options are American-style. That means they can be exercised any time up to expiration. Many index options (like SPX) are European-style and can only be exercised at expiration. If you sell American-style options, you can be assigned early.
Why do people use options?
- To define risk. A buyer knows the most they can lose up front: the premium.
- To hedge. An option can act like insurance on shares you already own.
- To collect premium. Sellers get paid to take on an obligation, and they carry the risk that comes with it.
Options are leveraged. A small move in the stock can mean a big percentage move in the option, in either direction. That cuts both ways.
Options also expire. A stock can be held forever. An option has a clock on it. When time runs out, the option either has value or it is worth nothing.
Before you can trade options, your broker must approve your account. Brokers use approval levels. Basic levels may allow buying calls and puts. Higher levels allow spreads or selling uncovered options. Each level carries more risk.
Worked example
Buying one call contract
Stock XYZ trades at $50. You look at a call option with a $50 strike that expires in 30 days. The premium is $2.00.
- Cost of one contract: $2.00 x 100 = $200. This is the most the buyer can lose.
- Scenario A, XYZ is at $56 at expiration: the call lets you buy at $50 stock worth $56. Value per share = $56 - $50 = $6.00. Per contract = $6.00 x 100 = $600.
- Net result in Scenario A: $600 value - $200 paid = $400 gain.
- Scenario B, XYZ is at $48 at expiration: there's no reason to buy at $50 when the market price is $48. The call expires worthless.
- Net result in Scenario B: $0 - $200 paid = $200 loss, the full premium.
The buyer's risk was capped at the $200 premium. The seller of that call collected $200 and had the opposite result in each scenario.
thinkorswim desktop (Windows)
Practice in paperMoney first
On the thinkorswim login screen, switch to paperMoney before you log in. paperMoney is TOS's simulated trading account. It uses the same tabs and option chains as live trading, so you can place practice option orders with no real money at risk. Use it for every exercise in this course.
Key takeaways
- An option buyer has a right; an option seller has an obligation.
- One standard equity option contract = 100 shares. Multiply the quoted premium by 100.
- Most U.S. stock and ETF options are American-style and can be exercised early.
- Options expire. Time is always part of the trade.
- Brokers require options approval levels, and higher levels carry more risk.
Module 1 quiz
5 questions for practice. No pass or fail. You can retake it.