What Is an Option?

Pay a little money to buy a “right”

An option is like a deposit on a house: you pay a premium for the right to “buy at an agreed price later”; the side that takes your money is the seller, who takes on an obligation.

Exercise if it pays, walk away if it doesn't

On the expiration date, you exercise if it pays and walk away if it doesn't. The most you can lose is the deposit you paid.

Two kinds of rights: to buy and to sell

A house deposit is the right to “buy at an agreed price later”, called a call option; the reverse, the right to “sell at an agreed price later”, is a put option, like buying insurance against the asset's price falling.

Key takeaways

• An option is a right: the buyer can choose to use it or not.
• The buyer pays a premium; the seller collects the premium and takes on the obligation.
• At expiration, the buyer exercises if it pays and walks away if it doesn't, losing at most the premium.
• A call is the right to buy at the agreed price; a put is the right to sell at the agreed price.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Drag “House price in a year” to $1,300,000 and press ▶: why do you choose to exercise at expiration? What's your net gain?
2. Drag it to $800,000 and play again: how much would buying the house outright lose? What's the most you lose with the deposit?
3. Try $1,000,000 and $1,050,000 in turn: which one do you walk away from and which do you exercise? The net P&L at expiration is −$20,000 and what?
4. Look at the comparison bar at the top: which option term does each of the house, $1,000,000, the $20,000 deposit and 12 months correspond to?

Quiz and explanations

1. At expiration, an option buyer finds that exercising isn't worth it. They…

Answer: Can walk away and lose the premium.A right isn't an obligation. The most you can lose is the premium you paid.

2. What's the money you pay to buy an option called?

Answer: Premium.The premium is the option's price.

3. You pay a $20,000 deposit for the right to buy a house for $1,000,000 within a year. At expiry the house is worth $1,010,000. What should you do?

Answer: Exercise: recover $10,000, net loss $10,000.The deposit is already spent. Exercising gets back $1,010,000 − $1,000,000 = $10,000, for a net loss of $10,000; walking away loses the full $20,000. So you should still exercise.

Terms in this lesson

• call option (Call): The right to buy the underlying at the strike price; the higher the stock goes, the more it's worth.
• exercise (Exercise): When an option buyer uses their right, buying (call) or selling (put) the underlying at the strike price.
• expiration date (Expiration): The last day an option is valid; after that, the right is gone.
• option (Option): A contract where you pay a premium for the right to buy or sell an asset at a set price in the future.
• premium (Premium): The price of an option, paid by the buyer to the seller; it's the most the buyer can lose.
• put option (Put): The right to sell the underlying at the strike price; the lower the stock goes, the more it's worth.
• strike price (Strike): The price written into an option contract at which you can buy or sell.
• underlying (Underlying): The asset an option contract is based on, such as a particular stock.
• option writer (Writer): The side that sells an option and collects the premium, taking on the obligation if the buyer exercises.