How it works
Four things define an option: what it is on (the underlying), the fixed price (the strike), the last day it can be used (the expiry) and whether it is a call or a put. The premium is the option’s own price, agreed in the market.
At expiry the arithmetic is simple. A call is worth the underlying’s price minus the strike if that is positive, and nothing otherwise. A put is worth the strike minus the price if that is positive, and nothing otherwise. The buyer’s result is that amount less the premium paid; the seller’s result is the exact opposite.
So a buyer can lose the premium and no more, and that happens whenever the option expires worth nothing. The seller keeps the premium in that case, but takes the other side of everything else: a call sold without owning the underlying has no limit to its loss, because a price has no ceiling, and a put sold can lose almost the whole strike.
Before expiry an option’s price also contains time value: a payment for what might still happen. It shrinks as expiry approaches, even if the underlying does not move. A listed option usually covers a fixed quantity of the underlying, often 100 shares, so every figure per share is multiplied by that quantity.
What it costs
- The premium, for a buyer: paid at the start and not returned.
- The spread between the buying and selling price of the option, which can be wide for options that trade little.
- A commission or contract fee on each trade, and sometimes a fee on exercise.
- Margin, for a seller: money that must be kept on deposit against the possible loss, and added to if the position moves against them.
The risks
- A buyer loses the whole premium if the option expires worth nothing, which is a common outcome.
- A seller’s loss can be many times the premium received and, for an uncovered call, has no upper limit.
- Time works against the buyer: the option loses value as expiry approaches.
- An option is a leveraged position. A small move in the underlying is a large percentage change in the option.
- An option’s price depends on expected volatility as well as on the underlying, so it can fall even when the underlying moves the “right” way.
Where people go wrong
- Being right about the direction and wrong about the date. An option that would have paid a week after expiry pays nothing.
- Forgetting the premium when working out the break-even. The underlying must pass the strike by the premium before a buyer is ahead.
- Selling options for the premium as if it were income. Small regular receipts can be followed by one very large loss.
- Forgetting the contract quantity, and so holding a position many times the intended size.
- Buying options far from the current price because they are cheap. They are cheap because they rarely pay.
Questions people ask
- What is the difference between a call and a put?
- A call gives its buyer the right to buy the underlying at the strike price; it gains value as the underlying rises. A put gives its buyer the right to sell at the strike price; it gains value as the underlying falls.
- What is the most an option buyer can lose?
- The premium paid, plus dealing costs. If the option expires worth nothing, the whole premium is lost. The buyer is never obliged to use the option.
- Why is selling options riskier than buying them?
- The seller receives the premium and in return takes on the obligation. The most the seller can gain is the premium; the possible loss is far larger, and for a call sold without owning the underlying it has no limit.
The words on this page
A general explanation for study, with invented examples. Costs, taxes and rules differ by country, market and product, and the documents of the thing itself are what count. Educational information, not investment advice or a recommendation to trade.