What is an option, in plain words?Start here

A right you buy, not a deal you are stuck with. You pay for it up front, and if you never use it, that payment is all you lose.

An option is the right to buy or sell something, at a price agreed now, up to a date agreed now — and no obligation to do it. You pay for that right up front. The payment is called the premium, and if you never use the right, the premium is what you lose. Nothing more.

What is a call and what is a put?

A call is the right to buy. You want it when you think the price is going up: you can buy at the old price while everyone else pays the new one.

A put is the right to sell. You want it when you think the price is going down, or when you already own the thing and want a floor under it.

An example. A share is at 100. You buy a call with a strike of 110, expiring in six months, and pay 4 for it. If the share reaches 130, you buy at 110 and it is worth 130 — 20 of value, less the 4 you paid, so 16. If the share ends at 105, the right to buy at 110 is worthless and you lose the 4. That is the shape of every option: a known, limited cost, and an outcome that depends on where the price lands.

Why did my option lose money when the market went my way?

The commonest question, and there are three ordinary answers.

It did not go far enough. A call struck at 110 that cost 4 needs the share above 114 just to break even. Up 3% is not up enough.

Time ran out of it. An option is partly a bet that something will happen before a date. Every day that passes with nothing happening, a bit of the value goes, and it goes faster near the end. This is called time decay, and it works against the buyer every single day.

The market calmed down. Options are worth more when prices are expected to swing about, because swinging is what gives the right its chance. If expected movement drops, the option gets cheaper even if the price has not moved at all. That is volatility, and it is why an option bought during a panic often loses money as the panic passes.

What does selling an option mean?

The opposite side, and it is not symmetric. The seller takes the premium and takes on the obligation. If the buyer exercises, the seller has to deliver.

So the seller's best case is the premium, and no more. The worst case can be far larger. That is a perfectly sensible trade — it is close to what an insurer does — but it is the reverse of the buyer's shape, and it is the reason selling options carelessly ends badly more often than buying them does.

Do I need to own the share to buy an option on it?

No. Most options are never exercised at all; the holder just sells the option itself before expiry, at whatever it has become worth. Many are settled in cash — the difference is paid, nothing changes hands.

Owning the underlying does change what the option is for, though. A put against shares you hold is insurance. A put on shares you do not hold is a bet. Same contract, different job.

Where do the prices come from?

From a formula that has been standard since the 1970s, plus a market of people disagreeing with it. The inputs are all knowable except one: how much the price is expected to move. Everything interesting about option pricing is an argument about that number. The equity option page has the calculator, and the strategy builder lets you combine several and see the shape of the result.

What should someone starting out actually take away?

• Buying: your loss is capped at the premium. That is genuinely useful and genuinely often lost in full.
• Time is against the buyer, every day, automatically.
• Being right about direction is not enough — size and timing both have to be right too.
• Selling has a different risk shape and deserves its own study before any of it.