What an option is

An option is a contract. It gives you the right to buy or sell a stock at a fixed price, up to a fixed date. It is a right, not a duty. If using it would lose you money, you don’t use it.

Think of a concert ticket. You pay a little now for the right to go later. Nobody makes you go. If you skip the show, you lose what the ticket cost and nothing more.

Here is a real example. A stock trades at $100. For $3.02 a share you can buy a call, which is the right to buy. This one lets you buy the stock at $100 at any time in the next 30 days.

The $100 is the strike: the price written into the contract. The last of those 30 days is the expiry. The $3.02 is the premium: the price of the option itself.

Options are sold in contracts, and one contract covers 100 shares. Prices are quoted per share, so one contract of this call costs $302.

Now suppose the stock climbs to $115. You can still buy at $100, which is $15 a share below the market. If it falls to $85 instead, you let the option expire. You lose the $302 you paid, and never more.

A put is the mirror image. It is the right to sell at the strike. The $100 put on the same stock costs $2.69 a share. It pays off when the stock falls. That is why people buy puts as insurance on shares they already own.

Why the right costs money

An option’s price has two parts.

Intrinsic value is what the option would be worth if you used it right now. With the stock at $110, a $100 call lets you buy $10 below the market. So it has $10 of intrinsic value. With the stock below $100, the call has none. Using it would mean paying more than the market price.

Time value is everything above that. You pay it for the chance that the option becomes worth more before expiry. Time value is never negative. The worst that can happen to an option you own is that it ends up worth nothing.

Move the stock price below and watch the premium split into its two parts.

Time value is largest at the strike, because that is where the outcome is least certain. At $100 the whole $3.02 is time value.

At $90 the call still costs $0.24. That is all time value: the stock could still climb $10 in 30 days. At $110 the call costs $10.62. Only $0.62 of that is time value. The other $10 is what it is already worth.

In, at and out of the money

Traders describe an option by where the stock sits against the strike.

• A call is in the money when the stock is above the strike. It has intrinsic value.
• It is at the money when the stock and the strike are about equal.
• It is out of the money when the stock is below the strike. It is all time value.

For puts it flips. A $100 put is in the money when the stock is below $100.

On the expiry date, time value runs out and an option is worth exactly its intrinsic value. Before that, its price moves with the stock, with the passing days, with how much the market expects the stock to swing, and with interest rates. The Greeks measure how the price responds to each one, and each Greek gets its own chapter.