Options Primer Part 2: What Options Are
What’s an option?
Here’s how Wikipedia defines it:
In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date.
One phrase at a time:
“The right, but not the obligation” - You can do something, but you don’t have to. If exercising the option would lose you money, you just… don’t. You walk away.
“To buy or sell” - There are two flavors. The right to buy is called a call. The right to sell is called a put.
“At a specified strike price” - The price is locked in when you buy the option. Doesn’t matter what happens to the market afterward.
“On or before a specified date” - Options expire. After that date, they’re worthless. (We’ll use “American-style” options, which can be exercised anytime before expiration.)
The catch? You pay for this right upfront. That payment is called the premium. If you never use the option, you lose the premium.
Meet WidgetCo
We need a stock to trade. Enter WidgetCo (ticker: WGT).
(“Widget” is a placeholder name economists use for a generic product. WidgetCo is our fictional company - a bland, stable industrial manufacturer. Think of it as “Generic Corp.”)
WidgetCo was founded in 1952 by Earl Widget in Akron, Ohio. Three generations of the Widget family ran it until 2019, when the last heir sold to a private equity consortium. Revenue: $2.3 billion. Employees: 12,000.
Stock’s at $100.
What’s a call option?
A call is a contract. It says: I have the right to buy this stock at a fixed price, no matter what happens.
WidgetCo is at $100. You buy a $100 call expiring in 30 days. It costs you $4.
That $100 is the strike price. It’s locked in. Doesn’t matter what happens next.
Say WidgetCo announces a breakthrough widget. Stock jumps to $150. Your call says: “I can buy at $100.” So you do. You buy at $100, sell at $150, pocket $50 per share. Minus the $4 premium, that’s $46 profit per share.
Or say WidgetCo’s factory burns down. Stock drops to $60. Your call still says “I can buy at $100” - but why would you? You wouldn’t. The contract expires unused. You’re out the $4 you paid, nothing more.
That $4 is the premium. It’s what you pay for the right. If you never use the right, you lose the premium. If you use it, your profit is whatever you made minus the premium.
A note on pricing: Options are quoted per share, but each contract controls 100 shares. So a “$4 option” actually costs $400 to buy. When you exercised at $100 and sold at $150, you made $50 per share - but that’s $5,000 total (100 × $50), minus the $400 you paid, for $4,600 profit.
This series quotes prices per share because that’s how you’ll see them displayed. Just remember: multiply by 100 for the actual cash changing hands.
Drag the slider to see how your call’s value at expiration depends on the stock price:
Below $100: flat at -$4. You lost the premium, nothing more. Above $100: slopes upward. You’re making money.
What’s a put option?
A put is the mirror image. It says: I have the right to sell this stock at a fixed price, no matter what happens.
WidgetCo is at $100. You buy a $100 put expiring in 30 days. Costs $3.50.
Say WidgetCo’s CEO gets arrested for fraud. Stock crashes to $50. Your put says: “I can sell at $100.” So you buy shares at $50 on the open market, then immediately sell them at $100 using your put. That’s $50 profit, minus the $3.50 premium = $46.50.
Or say WidgetCo announces record earnings. Stock jumps to $130. Your put says “I can sell at $100” - but the market will pay $130. Why sell at $100? You wouldn’t. Contract expires unused. You’re out $3.50.
Above $100: flat at -$3.50. Below $100: slopes upward.
Try it - make some money
Time to play. The simulator below lets you buy calls and puts on WidgetCo, then fast-forward time to see what happens.
The stock is being nice to you right now. Cooperative mode: it tends to drift in whatever direction makes your positions profitable. This is practice.
Try this:
- Buy a $100 call for around $4
- Hit “Fast Forward” to advance a week
- Watch the stock drift up. Your call gains value.
- Sell it. You just made money.
Now try a put:
- Reset the simulator
- Buy a $100 put for around $3.50
- Fast forward. Stock drifts down.
- Your put is now worth more. Sell it. Profit.
Play around. Get a feel for it.
The relationship isn’t 1:1
As you played, you might have noticed: the stock moved $8, but your option didn’t move $8. It moved less.
That’s delta - the ratio of option movement to stock movement.
Your call has delta of about +0.5. That means for every $1 the stock moves up, your call gains about $0.50. Your put has delta of about -0.5 - it gains $0.50 for every $1 the stock moves down.
We’ll formalize delta in Part 4. For now, just notice: options amplify your exposure (you paid $4 to control $100 of stock) but they don’t move 1:1.
Why delta isn’t constant
When the stock is at $100 and your strike is $100:
- Call delta is around +0.5
- Put delta is around -0.5
But watch what happens as the stock moves.
Stock rises to $110:
- Call delta approaches +1.0 (deep “in the money” - moves almost 1:1 with stock)
- Put delta approaches 0 (deep “out of the money” - barely moves)
Stock falls to $90:
- Call delta approaches 0 (deep OTM, barely moves)
- Put delta approaches -1.0 (deep ITM, moves almost 1:1 inverse with stock)
This is the second derivative from Part 1. Delta itself has a rate of change. That’s called gamma. We’ll cover it in Part 4.
What you’re actually buying
If options were perfectly priced, directional betting would break even. The $4 premium already reflects the market’s probability estimate. Over enough trades, wins and losses balance out.
So what are you paying for?
Exposure to volatility - whether the stock moves more or less than the market expects.
The option expires eventually. Every day that passes, it loses value. The right to buy at $100 is worth something today. Worth less tomorrow. Worth nothing after expiration.
And if the stock might move a lot, options are worth more. Dead calm? Worth less.
When you buy options, you’re betting the stock moves more than expected. When you sell them (Part 5), you’re betting it moves less.
Part 3 covers volatility - the key input to option pricing.
This is Part 2 of a 5-part series on options. Part 1 covers background. Part 3 covers volatility.