Options 101: Beginner Tutorial
If you are new to options, this page can be used as a beginner tutorial, guiding you through the basic terms and concepts. These are not only essential for successful options trading, but also needed for understanding more advanced topics such as option pricing, volatility, Greeks, or option strategies.
Summary / Reference
Options Basics: Overview of Basic Terms and Concepts – If you already know a bit about options, you can use this page as a checklist to make sure you understand all the fundamentals.
How Options Work
What Is an Option? – Options are derivative securities, representing a right (not obligation) to buy (call options) or sell (put options) the underlying security at a given price (the option’s strike price).
Strike vs. Market Price vs. Underlying Price – Three different prices often come up when discussing options. It is important to understand their differences and how they are related to each other.
5 Basic Characteristics of Every Option – Each option contract is defined by five basic parameters: underlying asset, option type (call or put), strike price, expiration date, and when the option can be exercised (American vs. European options). All these things are constant through an option’s life. They affect the option’s value, and thereby the ultimate trading profit or loss.
Exercising Options and Expiration – When you hold an option, there are three ways for you to stop holding it: you can sell it in the options market, you can exercise it, or the option can expire.
Intrinsic Value – Explaining the concept of intrinsic value, which is in fact not limited to options. In case of options, intrinsic value is generally what the holder of the option would gain by exercising the option immediately (and giving up its time value, which is the second component of an option’s total value).
Strike Price and Intrinsic Value of Call Options – Intrinsic value of call options is the positive difference between the underlying stock’s price and the option’s strike price, or in other words the money you would save when getting the underlying stock by exercising the option compared to buying the stock in the stock market. When underlying price is at or below the strike price, intrinsic value is zero, because exercising the option would not get the stock cheaper than in the stock market.
Strike Price and Intrinsic Value of Put Options – Put option intrinsic value follows the same logic as calls, only the direction is reverse, beceause a put represents a right to sell, not buy, the underlying security. Therefore, a put option’s intrinsic value is the positive difference between its strike price and underlying price (intrinsic value is positive when underlying price is below the strike price, and zero otherwise).
Option Intrinsic Value Formulas – A summary of call and put intrinsic value formulas.
In the Money, At the Money, Out of the Money Options – You will often come across these terms (or the acronyms ITM, ATM, OTM) when working with options. They are closely related to intrinsic value and the relationship between strike price and underlying price. They allow us to easily categorize options in three groups, with each having some shared characteristics when it comes to option premium, time value, and practical trading.
In the Money vs. At the Money Options: An Example – To make sure you fully understand moneyness, let’s have a look at six different call and put options on the same underlying stock, and see which of them are in the money, at the money, and out of the money.
Time Value of Options – Each option’s value (or premium) consists of intrinsic value (explained above) and time value. The latter is less simple to calculate, as it depends on a number of factors, such as time to expiration, volatility, or interest rates. Understanding time value and how it reacts to different factors is the key to profitable options trading.
The following pages explain time value for different kinds of options in greater detail:
- Time Value of In The Money Call Options
- Time Value of In The Money Put Options
- Time Value of Out of the Money Options
Putting it all together, the following two pages explain how call and put option prices are driven by changing intrinsic and time value:
Basic Option Positions
Let’s finally get to some actual options trading.
Call, Put, Long, Short, Bull, Bear: Terminology of Option Positions – There are four basic positions you can create with options: you can buy a call option, buy a put option, sell a call option, and sell a put option. Option positions are often referred to as long vs. short or bullish vs. bearish. It is important what these labels mean, as they are often source of confusion.
Directional Trades with Options – This page explains how you can use options to speculate on underlying price going up or down, just like you would do by trading the underlying stock itself. It turns out options have a number of advantages and differences compared to stock trading.
Understanding the basic concepts is really just the beginning. It is necessary, but far from enough for successful options trading. From here you can proceed to more advanced tutorials, which explaind option pricing, the Black-Scholes model, option Greeks, and option strategies.
Frequently Asked Questions
Can an Option’s Intrinsic Value Be Negative? – The short answer is no, and if you have gone through the intrinsic value tutorials above, you certainly understand why. This page provides some further clarification.
What Is the Difference between Strike Price and Spot Price? – Both start with S and are sometimes confused. Strike price is one of the basic characteristics of an option contract and it is fixed through the option’s life. Spot price is just another name for market price, i.e. what you pay for a security “on the spot”. If can refer to the option’s market price, but more often it means the underlying stock’s price as it is right now.