Options from the beginning: calls, puts, and the Greeks in plain words

What a contract actually is, what the numbers on the screen mean, and why an option's value before expiration is not the same as its payoff at expiration.

An option is a deal between two people about something that might happen later. One side pays for the right to choose. The other side gets paid for being on the hook. Everything else is detail, though the details matter a great deal.

The contract

A call gives its owner the right to buy 100 shares of a stock at a set price, the strike, on or before a set date, the expiration. A put gives the right to sell 100 shares at the strike. The 100 is standard for US stock options. The premium is the option's price, quoted per share, so a quote of $2.50 means $250 for one contract. American style options can be used on any day before expiration. European style, common on index options, only on the last day. Stock options settle in shares. Index options settle in cash.

The screen

An option chain lists every contract for a stock, by expiration and by strike. For each one you see a bid, what buyers will pay, an ask, what sellers want, the last trade, how many traded today, and open interest, which is how many contracts exist right now. A wide gap between bid and ask, and a small open interest, mean a contract is hard to trade at a fair price. Those two columns tell you more about your real cost than the premium does.

Intrinsic value and time value

A call with a $50 strike on a stock at $54 has $4 of built in value. If it trades at $5.50, the extra $1.50 is time value, the price of the chance that the stock moves further before the date. Time value melts toward zero as expiration approaches, faster in the last weeks. On the last day an option is worth exactly its built in value, which for an option that is out of the money is nothing.

The Greeks describe how an option's price reacts to changes. Delta is how much the price moves per one dollar move in the stock, and roughly the chance the option ends up in the money. Gamma is how fast delta changes. Theta is what the option loses each day from time passing. Vega is how much it moves when the market's expectation of volatility changes. Rho is sensitivity to interest rates, usually small. A position's Greeks are the sum of its parts, and a spread can have Greeks that look nothing like either leg on its own.

Implied volatility is the volatility number that makes a pricing model spit out the market price. It is the market's guess about future movement, not a measurement of past movement. Premiums rise before earnings because implied volatility rises. After the announcement it often collapses, and an option can lose value even when the stock moved the way you expected. That is the volatility crush people talk about, and it is a vega effect.

The expiration picture is not today's value

Payoff diagrams show what a position is worth on expiration day at every possible stock price. They are perfect for seeing the most you can make, the most you can lose, and where you break even. They say nothing about tomorrow. A bought call can lose money while the stock rises, if time decay and falling volatility outweigh the move. The calculator on this site draws expiration payoffs and labels them that way, because presenting them as today's value would mislead you.

Where the tidy version goes wrong

"Options are leverage" is true and incomplete. A call on 100 shares costs a fraction of the shares, so a small move makes a big percentage change, in both directions. Most out of the money options expire worthless. "You can only lose what you paid" is true for buyers and dangerously false for sellers of uncovered options, whose losses are limited only by how far the stock can move.

Questions worth asking yourself

What are the bid, ask, volume, and open interest on the exact contract? What is the implied volatility, and how does it compare with how much the stock has actually been moving? Is there an earnings date or dividend before expiration? What is the most the whole position can lose? And what do you expect to happen, by when, and what happens if you are right about the direction but wrong about the timing?

Sources

Written by one person and checked against the sources above; no outside expert has reviewed it yet. Rules and dollar limits change every year, so this guide explains how things work and sends you to the official source for this year's numbers.