Options 101: Understanding the Basics of Financial Options

The article “Options 101: Understanding the Basics of Financial Options” first appeared on Robot Wealth blog.

In the previous article, we discussed what makes an option valuable. At its core, an option is about choice—the choice to buy or sell an asset at a specific price within a set timeframe. In this article, we’ll explore exactly what this means.

An option gives the holder the right, but not the obligation, to trade a certain amount of the underlying asset at a specific price on or before a certain date.

Let’s break down each of the terms.

An option gives the holder the right, but not the obligation, to trade…

What makes options useful is that they, err, give you options.

• If you buy a call option, it gives you the option to buy the underlying asset.
• If you buy a put option, it gives you an option to sell the underlying asset.

…a certain amount of…

A single option gives the holder the option to trade a certain amount of the underlying asset.

This is called the contract unit or the contract multiplier.

• For US stocks, a single option gives you the option to trade 100 shares (assuming they haven’t split).
• For equity index options, the index value is usually 100 times that of the index value.
• For futures options, it is one futures contract.

..the underlying asset…

The underlying asset is the product (spot product) to which the option relates. Options are available on stocks, indices, and futures.

…at a specific price…

The price the holder of the option can trade at is called the strike price.

• The holder of a call option can buy at the strike price.
• The holder of a put option can sell at the strike price.

…on or before a certain date.

This is the expiration date of the option, which is the last day the option contract exists.

The holder of the option can exercise their right to buy or sell at the strike price on or before the expiration date.

• A European option can only be exercised on the expiration date.
• An American option can be exercised anytime before or on the expiration date.

An Example

• $200 calls on TSLA, expiring on 17 July 2024.
• American option. Contract unit: 100.

The owner of these calls has the option to buy 100 TSLA shares at $200 on or before 17 July 2024.

At the time of writing TSLA is trading at $180.

So you could buy TSLA shares cheaper in the market than you could by exercising this option. So, the intrinsic value of this call option is $0. It’s not intrinsically valuable to us right now.

If TSLA were trading at $210, then the option is intrinsically valuable. You could exercise the option, buying 100 shares of TSLA stock at $200, then immediately sell them on the stock market for a profit of $10 per share.

If the option has some time left to expiry, then it’s always going to have some value, because the TSLA share price is volatile. As long as there is a chance that the price will exceed $200 by 17 July 2024, the option will have some value.

How much value? We’ll get to that next.