By the FinLingo Team | Capital markets practitioner, front office experience at a major European investment bank. FinLingo covers 342 lessons from bonds to exotic derivatives. About · Last updated:
An option is a contract that gives the buyer the right — but not the obligation — to buy or sell an underlying asset at a predetermined price (the strike) before or on a specific date (the expiry). The buyer pays a premium for this right. The seller (writer) collects the premium and takes on the obligation.
A call option gives you the right to buy. You buy a call when you think the underlying will rise. A put option gives you the right to sell. You buy a put when you think the underlying will fall. These are the two building blocks. Every options strategy — from a simple hedge to a complex structured product — is built from combinations of calls and puts.
You buy a call option on a stock trading at $100 with a strike price of $100 and an expiry in 3 months. You pay a premium of $5. If the stock rises to $115 at expiry, your option is worth $15 (the difference between stock price and strike). Your profit is $15 minus the $5 premium = $10, a 200% return on your investment. If the stock stays at $100 or falls, the option expires worthless and you lose the $5 premium. That is your maximum loss.
Options provide leverage and asymmetry. The call buyer above risked $5 to gain exposure to a $100 stock. If the stock rose 15%, the option returned 200%. If the stock fell 20%, the buyer lost only $5 — not $20. This asymmetric payoff is what makes options fundamentally different from forwards or futures, where both sides have symmetric obligations.
An option's price has two components. Intrinsic value is what the option would be worth if exercised immediately: max(S − K, 0) for a call. Time value is everything else — the premium you pay for the possibility that the option could become more valuable before expiry. Time value decays as expiry approaches, accelerating in the final weeks. This decay is measured by theta.
A call option gives the buyer the right to buy an asset at the strike price, profiting when the price rises above the strike plus premium. A put option gives the right to sell, profiting when the price falls below the strike minus premium. Call buyers are bullish; put buyers are bearish.
If an option expires out of the money (stock below strike for calls, above strike for puts), it expires worthless. The buyer loses the entire premium paid. The seller keeps the premium as profit. There is no further obligation for either party.
Time value reflects the probability that the option could move into the money before expiry. More time means more chance of a favorable move, so longer-dated options cost more. As expiry approaches, time value decays (theta decay), accelerating in the final weeks. At expiry, time value is zero and only intrinsic value remains.
FinLingo covers options mechanics in Level 2 (7 units) and options pricing in Level 3 (8 units). Level 1 is free.
Start Free