What Are Options & How Do They Work?

What is an option?

An option is a financial contract whose value is derived from an underlying asset, index, or a set of assets. The value of an option is based on the value of other financial assets like stocks, ETFs, bonds, commodities, currencies, interest rates, or futures. 

Options provide the holder with the right - but not the obligation - to buy or sell the underlying asset. Options are somewhat unique because they have an associated expiration date and time.

Due to their flexibility and dynamic nature, options are often used by investors and traders for the purposes of hedging, but may also be used for speculation and/or arbitrage. 

How do options work?

The mechanics of an options transaction are fairly simple - one party (the option seller/writer) sells an options contract (or multiple contracts) to another party (the option buyer/holder). 

The contract offers the buyer the right, but not the obligation, to buy (calls) or sell (puts) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time prior to the options expiration date.

An option’s value is intrinsically linked to the value of an underlying asset or set of assets like stocks, bonds, commodities, currencies, interest rates, or market indices. 

As such, the relationship between the value of an option and its underlying asset can be complex and is often determined by a variety of factors including, but not limited to, the price of the underlying asset, time decay, volatility, and interest rates.

The concept of "moneyness" is crucial in the options world because the relative moneyness of an option may dictate how an investor or trader decides to use (or not use) an option in a given trading strategy. The moneyness of a given option provides an investor or trader with a basic idea of its risk and reward profile. 

The two primary components of an option’s value - intrinsic and extrinsic value - provide further perspective on the concept of moneyness. In the options world, intrinsic and extrinsic value represent the total value (aka price or premium) of an option. 

The intrinsic value of an in-the-money (ITM) option at expiration is the difference between the strike price and stock price. For expiring out-of-the-money (OTM) options, this value is zero.

Extrinsic is the term used for the value of an option beyond its intrinsic value. Stated differently, extrinsic value is the part of the option premium that is not intrinsic value. 

Taken all together, that means for a call option to be ITM, the current market price of the underlying asset must be higher than the option's strike price. And for a put option to be ITM, the current market price of the underlying asset must be lower than the option's strike price. 

The intrinsic value of an ITM call option is calculated as the difference between the current market price and the strike price, while for an ITM put option, it's also the difference between the strike price and the current market price.

An option may also be categorized as “at-the-money”, but the definition of an at-the-money option is slightly less rigid than that of ITM and OTM options.

In general, an ATM option is one in which the current market price of the underlying asset is very close to or equal to the strike price of the option. That means an ATM may not have a high intrinsic value, but it may be rich in so-called “time value.”

In options trading, time value refers to the portion of an option's premium that is attributable to the amount of time remaining until the option's expiration date. Time value is therefore a component of an option's extrinsic value, not its intrinsic value.

Listed below are some additional concepts that are critical for trading options. 

  • Strike Price: This is the price at which the asset will be bought or sold if the option is exercised.

  • Expiration Date: The date and time at which the option expires. After this, the option ceases to exist. 

  • Premium: The price that the option buyer pays to purchase the option. Alternatively, this is the income received by the option writer (seller).

  • Underlying Asset: An option is based on an underlying asset, which can be stocks, bonds, commodities, currencies, indexes, or interest rates.

  • Exercise: When the holder of an option decides to buy/sell the underlying asset at the strike price, it is called exercising the option.

  • Assignment: When an option writer (seller) is obliged to sell/buy the underlying asset to/from the option holder, it's known as being assigned.

  • American vs. European Options: American-style options can be exercised at any time before or on the expiration date, whereas European style options can only be exercised on the expiration date, not before. 
    Strategic Purpose: Used for hedging and speculative activities. For example, a stock investor might purchase a put option to protect against a potential price drop in the underlying stock.

Options Summary

  • Mechanics: Provides the option holder with the right, but not the obligation, to buy (call) or sell (put) an asset at a predetermined price (strike price) by or on a specific date.
  • Markets: Can be traded on exchanges or over-the-counter (OTC).

Call and Put Options

There are two types of options - calls and puts - as outlined below: 

  • Call Option: Provide the holder with the right, but not the obligation, to buy an asset at a specified price within a specific period of time. The buyer of a call option might therefore expect the underlying to increase in price, or seek to protect against an increase in the underlying asset. Learn more about call options.

  • Put Option: Provide the holder with the right, but not the obligation, to sell an asset at a specified price within a specific period of time. The buyer of a put option might therefore expect the underlying to decrease in price, or seek to protect against a decline in the underlying asset. Learn more about put options.  

Options pros and cons

Options offer a range of benefits but also come with significant risks. Some of the high-level pros and cons are outlined below. 

Advantages of Options

  • Risk Management (Hedging): Options can be an effective way to manage various types of risk, including price, interest rate, and currency risk. Businesses and investors can use them to lock in costs or revenues, protecting against adverse market movements.
  • Leverage: Because options often require a small upfront investment to control a more valuable asset, they can offer significant leverage. That means a small price movement in the underlying asset can result in large profits. However, the flip side is also true, and such leverage can produce large losses, as well. 
  • Speculation and High Returns: For those looking to speculate on asset prices, options offer the potential for high returns, again due to the leverage involved.
  • Market Efficiency: By allowing for hedging and speculation, options can contribute to more liquid and efficient markets.
  • Capital Efficiency: Options can sometimes be a more capital-efficient way to gain exposure to an asset without buying the underlying asset itself. 
  • Diversification: Options can help investors create more diversified portfolios. For example, investors can use options to construct 'synthetic' positions in assets or markets that might otherwise be difficult to access.
  • Flexibility: Especially in the case of OTC options, contracts can be customized to suit the specific needs and risk profile of the parties involved.
  • Income Generation: Using strategies like covered call writing, options can be used to generate additional income in an investment portfolio.

Disadvantages of Options

  • Complexity: Options can be extremely complex and are often poorly understood, even by sophisticated investors. This complexity can lead to significant financial losses.
  • Leverage Risks: For option sellers, the same leverage that can lead to large profits can also result in large losses, possibly exceeding the initial investment.
  • Counterparty Risk: In OTC options, there's a risk that the counterparty will default, potentially leading to significant losses.
  • Liquidity Risk: Some options, especially complex or customized OTC products, may be difficult to unwind/exit, posing liquidity risks to the holder. 
  • Market Risk: Just like any financial investment, options are subject to market risks caused by unexpected changes in market variables like asset prices and interest rates. 
  • Systemic Risk: Large-scale trading or a major default in options can lead to systemic risks, affecting broader financial markets and institutions, especially for OTC and exotic options. This was evident during the 2008 financial crisis.
  • Costs and Fees: While the use of options can be capital efficient in some instances, the use of options may also involve commissions, bid-ask spreads, and other trading costs that can eat into profits.
  • Opportunity Costs: When used for hedging, the elimination (or reduction) of downside risk can also equate to giving up potential upside gains. 

Options example

A basic example from the options universe is outlined below: 

An investor buys a call option for Apple stock with a strike price of $150, expiring in one month. If Apple's stock price rises above $150 within that month, the investor can exercise the option to buy shares at $150, potentially selling them for a profit at the current higher market price. In this instance, the investor might instead elect to sell the option for a profit, prior to expiration.

Option types

Options come in various forms and can be classified based on different criteria. Listed below are some of the common classifications and types of options:

  • Stock/Equity Options: Options where the underlying asset is stock.

  • Index Options: Options where the underlying asset is a stock market index.

  • Forex Options: Options based on foreign exchange rates.

  • Commodity Options: Options based on commodities such as gold, oil, or agricultural products.

  • Bond Options and Interest Rate Options: Options on bonds or interest rates.

  • Futures Options: Options where the underlying asset is a futures contract.

  • Exchange-Traded Options: Standardized options that are traded on organized exchanges with clear specifications regarding expiration dates, strike prices, and lot sizes.

  • Over-the-Counter (OTC) Options: Customized options traded directly between two parties without going through an exchange. They are more flexible but come with higher counterparty risk.

  • Exotic Options: A broad term for options that have features or payoffs that are different from traditional (plain vanilla) options.

It’s important to note that options have associated dates of expiration, and investors and traders should ensure they know the expiration date of a given option before entering a position. Some of the key differences between monthly, weekly, zero-day (aka 0DTE) and LEAPS options are outlined below. 

Monthly Options

  • Expiration: Traditionally, options contracts were available only as monthly expirations. They expire on the third Friday of the specified month.

  • Liquidity: Because they've been around the longest, monthly options typically have higher liquidity than weekly options but can vary based on the underlying asset.

  • Usage: They are often used for medium-term hedging and trading strategies.

Weekly Options

  • Expiration: Weekly options, as the name suggests, generally expire at the end of the trading week, typically on Fridays. 

  • Liquidity: They might have lower liquidity compared to monthly options, leading to wider bid-ask spreads. However, popular assets might have relatively high liquidity even for weeklies.

  • Usage: Due to their short lifespan, they are used for very short-term trading strategies, earnings plays, or quick hedging needs.

Zero-Day Options (aka 0DTE Options)

  • Expiration: Options with zero days until expiration only exist for a single trading session. Therefore, a 0DTE option could be a longer-term option that has reached the last day of its lifecycle, or it could be a specific option that’s listed only for a single day.

  • Liquidity: Given the extremely short lifespan, liquidity can be limited for these options. However, they might still see activity on highly volatile days or around specific events for high-volume underlying assets.

  • Usage: 0DTE options are primarily utilized by short-term speculators aiming to profit from intraday movements of the underlying asset or by traders looking for extremely short-term hedges against known events. Due to their nature, they are quite speculative and can be very risky.

Learn more about Zero Days to Expiration (0DTE) options.

LEAPS (Long-term Equity Anticipation Securities) Options

  • Expiration: LEAPS are long-term options contracts that can have expiration dates up to three years in the future. 

  • Liquidity: Liquidity can vary, but in general, LEAPS may have lower liquidity than shorter-term options.

  • Usage: Investors use LEAPS for long-term hedging or as a substitute for owning the underlying stock. For example, instead of buying stock, an investor might buy a LEAPS call to participate in potential upside with a fraction of the investment.

Why trade options?

Options serve various purposes in financial markets and can be employed by different types of participants, including individual investors, financial institutions, and corporations. Some of the reasons for trading options include: 

  • Risk management

  • Speculation

  • Arbitrage

  • Portfolio Management

  • Income Generation

While options can be useful for various strategic objectives, they come with their own set of risks and complexities. As such, they are generally best-suited for sophisticated investors and traders who understand these risks and have the means to manage them.

For these reasons, always trade responsibly, and consider consulting with a professional before engaging in options trading.

How to trade options

Some of the high-level steps and considerations for trading options are outlined below.

Education and Research

  • Learn the Basics: Understand the fundamental concepts of options, including how they work and the risks involved.

  • Research Strategies: Familiarize yourself with trading strategies like hedging, speculation, and arbitrage. Choose the one that aligns with your financial goals and risk tolerance.

Choosing a Platform and Account

Planning and Analysis

  • Develop a Trading Plan: Outline your objectives, risk tolerance, and strategies. Determine the kinds of options that suit your plan.

  • Analysis: Consider fundamental and technical analysis, and other strategic approaches, in order to identify trading opportunities. This should help you determine attractive entry and exit points.


  • Place Orders: Use the trading platform to place orders. Familiarize yourself with order types like market, limit, and stop orders.

  • Margin and Leverage: Be aware that trading on margin (borrowing money to trade) amplifies both potential gains and potential losses. Make sure to manage your leverage carefully.

Risk Management

  • Position Sizing: Don't put all your capital into a single trade; consider diversifying across different assets or asset classes.

  • Monitor the Position: Keep an eye on your open positions and be prepared to adjust them.

  • Position Management: Use orders like stop-loss or take-profit to automatically close your position when it reaches a certain loss or profit level.

Portfolio Analysis

  • Track Performance: Regularly review your trades to see what's working and what isn't.

  • Adjust Strategy: Refine your trading plan and strategies based on performance, or any changes in your outlook, strategic approach, or risk tolerance. 

Options vs. futures: what are the differences?

Options and futures are both financial derivatives used for hedging and speculative purposes, but they have several key differences, as outlined below. 


  • Options: Contracts that provide the holder the right, but not the obligation, to buy (call) or sell (put) a specified amount of an underlying asset at a predetermined price (the strike price) within a set time frame.
  • Futures: Contracts that obligate the buyer to purchase, and the seller to sell, a specified amount of an underlying asset at a predetermined price on a specified future date. Learn more about what futures are and how they work.

Obligation vs. Right

  • Options: Provide the right but not the obligation to the holder.
  • Futures: Create an obligation for both parties involved. The buyer is obligated to take delivery, and the seller is obligated to provide the asset at contract maturity.


  • Options: The buyer pays a premium to the seller (writer) of the option. This premium is the maximum amount the buyer can lose.
  • Futures: There's no upfront premium. Instead, parties post margin with a clearinghouse. Losses can be substantial for both parties.


  • Options: The maximum risk for the buyer is the premium paid. For the seller, the risk can be substantial, especially if they've written a naked option (an option not covered by ownership of the underlying asset).
  • Futures: Both parties face potentially unlimited risk, depending on market movements, until they close their position or the contract expires.


  • Options: Can be cash-settled or settled by delivering the underlying asset, depending on the option type.
  • Futures: Typically settled by delivering the underlying asset, though some futures contracts are cash-settled.


  • Options: Often used for hedging and providing flexibility since the holder isn't obligated to exercise the option.
  • Futures: Used for hedging and speculating on price movements. They are also commonly used by producers and consumers of commodities to lock in prices.


  • Options: The buyer pays a premium and doesn't have to deposit additional margin. Sellers may have margin requirements, especially if the option is naked.
  • Futures: Both parties need to post initial margin and may face margin calls if the market moves against their position.


Both options and futures offer leverage, meaning they allow for control over a large position with a relatively small amount of capital. However, the specifics of leverage and potential returns/losses can vary considerably between the two.

Options vs. stocks: what are the differences?

Options and stocks represent two different types of investment vehicles, each with its own characteristics and risk profiles. Some of the key differences are outlined below. 

Ownership & Rights

Stocks: When you buy a stock, you become a shareholder and own a piece of the company. This may come with rights such as receiving dividends (if the company pays them) and voting at shareholder meetings.

Options: Buying an option doesn't give you ownership of the company. Instead, it gives you the right, but not the obligation, to buy (call option) or sell (put option) a stock at a predetermined price (strike price) within a specified period.

Life Span

Stocks: Stocks don't expire. As long as the company is publicly traded, and doesn’t go bankrupt, you can hold onto the stock indefinitely.

Options: Options have expiration dates. After this date, the option becomes worthless if it hasn't been exercised.

Investment Objective

Stocks: Investors typically buy stocks to benefit from price appreciation and potentially dividends.

Options: Investors and traders use options for various purposes, including speculation on stock price movements, income generation (through strategies like covered calls), and hedging against potential adverse movements. 

Risk Profile

Stocks: The maximum loss when buying stocks is the amount invested. The stock price can go to zero, but no lower.

Options: For buyers, the maximum loss is the premium paid. However, sellers/writers of options can face significant or unlimited risks, depending on the type of option and whether it's covered.


Stocks: When buying stocks, you pay the full share price multiplied by the number of shares (plus any commissions or fees). Margin may also be used to buy stocks. 

Options: Buyers pay a premium, which is generally much less than the cost of buying the equivalent number of stock shares outright. This premium is determined by several factors, including the stock's current price, the option's strike price, time until expiration, volatility, and interest rates.

Dividends & Voting Rights

Stocks: Stockholders may receive dividends (if distributed) and have voting rights in the company.

Options: Option holders do not receive dividends and don't have voting rights. 


Stocks: Typically, there's no leverage unless you are trading on margin.

Options: Options provide leverage. Using a relatively small amount of capital (the option premium), you can control a larger position in the underlying stock.


Stocks: You can buy, sell or short stocks. 

Options: Offer a wider range of strategic possibilities, such as protective puts, covered calls, spreads, straddles, and more.

Top options trading strategies

There are numerous option strategies employed by traders and investors for various purposes, including speculation, income generation, and hedging. Here are five of the most commonly used option strategies:

1) Covered Call

Objective: Generate additional income from a stock position.

Strategy: An investor who owns shares of a stock sells (writes) call options on that stock. If the stock stays below the option's strike price, the option will expire worthless, and the investor keeps the premium. If the stock rises above the strike price, it might be called away, meaning the investor would have to sell the stock at the strike price.

2) Married Put

Objective: Hedge against a potential decline in a stock's price.

Strategy: An investor buys a put (or multiple puts) on a stock they already own. If the stock price drops, the put option's value will likely rise, offsetting the stock's decline.

3) Long Call Vertical Spread

Objective: Profit from a moderate rise in the stock price at a reduced cost.

Strategy: Buy a call option with a particular strike price and sell another call option (on the same underlying stock) with a higher strike price. Both options should have the same expiration date. The premium received from the sold call helps offset the cost of the purchased call, but it also caps the maximum potential profit. Learn more.

4) Long Put Vertical Spread

Objective: Profit from a moderate decline in the stock price at a reduced cost.

Strategy: Buy a put option with a particular strike price and sell another put option (on the same underlying stock) with a lower strike price. Both options should have the same expiration date. The premium received from the sold put reduces the overall cost of the strategy, but it also caps the maximum potential profit. Learn more.

5) Iron Condor

Objective: Generate a profit when the stock price remains within a specific range.

Strategy: An iron condor is constructed by combining a short strangle with a long strangle—the latter offering protection against a big move in the underlying. Unlike a pure short strangle, an iron condor is a defined-risk position, which means the worst-case scenario (i.e. maximum potential loss) is known prior to trade deployment.

Each of the aforementioned strategies has its own risk and reward profile. Before using any option strategy, it's crucial to understand how it works, its potential benefits and risks, as well as the specific market conditions for which it might be well-suited. Learn more.

Discover the 10 most popular options trading strategies every trader should know.

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