Investing: Options Trading

An option is a financial derivative that gives the buyer the right — but not the obligation — to buy or sell an underlying asset at a specified price before a set expiration date.

• Each standard options contract controls 100 shares of the underlying stock.
• The buyer pays a premium to the seller (writer) for this right. The premium is the maximum the buyer can lose.
• Options serve three main purposes: hedging existing positions, generating income, and speculating on price movements.
• Options expire worthless if the underlying asset does not move favorably before the expiration date.

Term	Definition	Example
Underlying Asset	Security the option is based on	Apple stock (AAPL)
Contract Size	Shares controlled per contract	100 shares
Premium	Price paid for the option	$3.00 × 100 = $300
Expiration	Date the contract ends	Third Friday of the month
Strike Price	Price at which the right applies	$180 per share

Options come in two types, each suited to a different market outlook:

• Call Option: Gives the buyer the right to buy the underlying asset at the strike price. Buyers profit when the stock rises above the strike price plus the premium paid. Calls represent a bullish directional view.
• Put Option: Gives the buyer the right to sell the underlying asset at the strike price. Buyers profit when the stock falls below the strike price minus the premium paid. Puts represent a bearish directional view or a hedge against an existing long position.

Type	Right	Profitable When	Common Use
Call Option	Buy at strike price	Stock rises above strike + premium	Speculation, leverage
Put Option	Sell at strike price	Stock falls below strike − premium	Hedging, bearish bets

• An option is in-the-money (ITM) when it has intrinsic value. A call is ITM when the stock price exceeds the strike; a put is ITM when the stock price is below the strike.
• An option is out-of-the-money (OTM) when it has no intrinsic value — only time value remains.

The Greeks measure how an option's price responds to changes in market conditions. Understanding them is essential for active options management.

• Delta (Δ): Measures how much the option price changes for every $1 move in the underlying stock. A delta of 0.50 means the option gains $0.50 if the stock rises $1. Calls have positive delta (0 to 1); puts have negative delta (−1 to 0).
• Theta (Θ): Measures time decay — how much value the option loses each day as expiration approaches. Theta works against buyers and in favor of sellers. An option with theta of −0.05 loses $5 per day per contract.
• Vega (V): Measures sensitivity to changes in implied volatility. Higher implied volatility increases option premiums. Vega matters most around earnings announcements or major economic events.
• Gamma (Γ): Measures the rate of change of delta. High gamma means delta changes rapidly as the stock moves — important for short-dated, at-the-money options.
• Rho (ρ): Measures sensitivity to interest rate changes. Rho matters more for long-dated options and in high-rate environments.

Options strategies range from simple income generation to complex multi-leg structures:

• Covered Call: Own 100 shares of a stock and sell a call option against them. Generates income from the premium but caps upside. Best in neutral-to-mildly bullish markets.
• Protective Put: Own shares and buy a put option. Acts as portfolio insurance, limiting downside losses in exchange for the premium cost. Best when protecting a large unrealized gain.
• Cash-Secured Put: Sell a put option while holding enough cash to buy the shares if assigned. Generates income and can be used to enter a stock position at a lower price.
• Bull Call Spread: Buy a lower-strike call and sell a higher-strike call. Reduces the cost of directional exposure while capping maximum profit.
• Iron Condor: Sell an OTM call spread and an OTM put spread simultaneously. Profits when the stock stays within a defined price range. Risk is limited and defined.
• Straddle: Buy both a call and a put at the same strike and expiration. Profits from a large move in either direction — useful before high-uncertainty events.

Strategy	Market View	Max Loss	Max Gain
Covered Call	Neutral to bullish	Stock loss minus premium	Premium + upside to strike
Protective Put	Bullish with hedge	Premium paid	Unlimited upside
Iron Condor	Sideways	Width of spread minus credit	Net credit received
Straddle	High volatility expected	Total premium paid	Unlimited (calls)

Options carry unique risks that differ significantly from stock investing:

• Leverage Risk: A small percentage move in the underlying stock can cause a large percentage gain or loss in the option's value.
• Time Decay: Options lose value every day, accelerating sharply in the final weeks before expiration. Buyers fight time decay; sellers benefit from it.
• Implied Volatility Risk: Buying options during high-volatility periods (such as earnings season) can result in losses even if the stock moves in the right direction — a phenomenon called IV crush.
• Assignment Risk: Sellers of options may be assigned at any time before expiration, requiring them to buy or sell 100 shares per contract.
• Liquidity Risk: Options on smaller stocks may have wide bid-ask spreads, increasing the effective cost of each trade.

Best practices:

• Paper trade for at least 30 days before using real capital.
• Limit options to a defined percentage — many advisors suggest no more than 5%–10% of a portfolio.
• Use defined-risk strategies (spreads, covered calls) until you understand unlimited-risk positions thoroughly.
• Consult a financial advisor before using options for significant hedging or income strategies.