Eli5: What are options in finance?


On a basic level what are options and options trading?

In: 1

You pay money for the ability to buy or sell a stock at in a set period of time. A call option is one that lets you buy it during a set time period, and a put option lets you sell it during the defined period.

Employee stock options at their most basic form are a perk to allow employees to buy shares in their company at a discounted rate.

Let’s say a company’s share price is £1.20, they’d typically offer options at a slight discount, to aid my maths here let’s say £1.00

You as an employee sign up for £10 per month of stocks for 5 years = £600 invested. This would typically be paid direct out of salary. And depending on the tax laws of the country you’re in may be deducted pre tax for a further benefit.

If at the end of 5 years the share price has gone up to £2.00, you’ve made a £600 profit.

If they’ve gone down to £0.50 you take your £600 and walk away.

an option is a contract that gives you the right to buy or sell a security at a specified price, within an agreed upon window of time. In other words, it’s a bet put down in writing.

let’s break that down.

1. An option is a contract. That means it’s an agreement between to parties. Every option has a party and a counter-party who is on the opposite side of the bet as you.
2. An option comes with a fee. They aren’t free. You have to buy options in order to have the right to buy or sell.
3. An option comes with an expiration date. If you haven’t exercised the option before then, it becomes null and void.
4. An option that gives you the right to buy a security is a Call option. An option that gives you the right to sell a security is a Put option. You would buy a Call option if you think the security’s price is going to be higher in the future. You lock in the right to buy it at a lower price today and then buy it for that price in the future when it’s worth more. You would buy a Put option if you think the security’s price will go down in the future. You lock in the right to sell it at today’s price which you expect will be higher than what you could sell it for in the future.

Options are a contract whereby the buyer of the option is buying the right to buy or sell a set number of shares at a set price within a specific time window. Let’s just consider an option to buy (sell is the same in reverse).


Strike Price — agreed upon price to be paid per share of stock

Expiration Period — time within which you must exercise your option or it becomes worthless

Premium — amount paid for the contract. You are out this money whether or not you exercise the contract

Exercise — to invoke your right to purchase the shares

An options contract is merely a contract where the one selling the contract agrees to sell you a set number of shares for a specific price before a certain time. You pay the price in the contract regardless of what the current market price of the stock is. You do not have to exercise (buy the stocks) if you do not want to, but you can. If you chose not to exercise the contract then you are out only the cost of the premium (see above for term definitions).

Why would you want to do this? It is a form of risk management and leverage. Let’s say you a company is currently selling at $100/share. You think in a few months it is really going to go up in value. You buy a 6-month option with a strike price of $150 per share and a $10 per share premium.

You owe 10*100 = $1000 for the premium. At anytime within six months you can exercise the option and purchase 100 shares at $150 each ($15000). It doesn’t matter if the current market price of the stock jumped to $1000 per share before you decide to exercise the option, you get to buy it at $150 per share.

Let’s say 4 months after purchasing the options contract the market price is $300 (they had really good news and the stock price jumped). You decide to exercise your contract. You owe $150 * 100 shares = $15000 and now have 100 shares of the stock. You can then sell those 100 shares for the current market price of $300 and get back $300 * 100 = $30000. Remember that you paid a $1000 premium for the contract so in the transaction you made $30000 (market value of shares) – $15000 (purchase price of shares) – $1000 (premium) = $14,000. You just made $14,000 on a $1000 investment (note these numbers are a made up example and may not reflect realistic premiums). In actual practice, the contract option itself has a value very similar to the market value of the shares, so you could just sell the options contract for the $14000 (or so) dollars without ever actually buying the $15000 worth of stocks–this is the leverage type ability of options.

Let’s say instead of going up $300, the stock crashed and burned down to $25 per share. In this case, you do not exercise your option and you lose your $1000 premium. If you’d actually purchased the stock at $100 per share, then you’d be out 100 * ($100 – $25) = $7500 which is $6500 more than not exercising the options contract. This is the risk mitigation property of options.

NOTE: This explanation makes options sound like options are no brainer–you win more when you win and lose less when you lose. What isn’t explained here is that you will in general lose money more often with the options contract than with buying the stock directly so it isn’t a black and white better than investing in the actual stocks. Unless you really know what you are doing, I’d recommend against playing in the options market (I have never made an options trade because while I understand them in principal I don’t trust my ability to use them more correctly than just buying the stocks). There are also a lot more complicated options available.

An option is the right but not the obligation to act on something, usually at a set price within a set time period.

Example: Let’s say Amazon is trading at $100. A buy option (referred to as a Call) could be the the right to buy a share of Amazon for $110 anytime in the next 12 months. And it might cost me $10. So I pay $10 for sure right now. If the stock rises to $111 or higher, then I can exercise my right and buy it for only $110. If it doesn’t rise to $110, then I don’t exercise my option and nothing happens. If it goes to $140, then I can use my option, sell it for that and put the $30 (140-110) in my pocket, leaving me with a profit of $20 after the $10 it cost to buy it.

Options trading simply would be if a bunch of people get together and trade those options. You and I could do that right now: I think Amazon is going to tank next year, and drop to $80. I’ll sell you that right to ‘buy Amazon if it goes over $110 for only $5. You love Amazon and say deal, we write the contract and both sign. Tomorrow Amazon reports record profits and 3 department stores go out of business. We all agree Amazon is a now much better stock. You think instead of $5 it’s now worth $20. I think it’s worth $50. I offer you $25 and you accept. We just traded it.