What it means
Four details define every option: the underlying asset, the strike price at which the trade can happen, the expiry date, and whether it is a call or a put. Everything else, including the premium, follows from those four features plus current market conditions.
Options matter to ordinary businesses far more than most people expect. An airline can cap its fuel cost with call options, an exporter can protect an exchange rate with puts, and employee share schemes are options in all but name.
The appeal for a buyer is asymmetry. The maximum loss is the premium paid, while the potential gain can be many times that amount, which is why options are used both to speculate and to buy insurance against a bad outcome.
For the seller the position is reversed: a capped gain equal to the premium and a potentially very large loss. Selling options without owning the underlying asset is how otherwise sensible traders get into serious trouble, because the downside is not limited by the size of the premium received.
Most options are never actually exercised; holders simply sell the contract back before expiry to capture whatever it is worth. Standard exchange-traded equity options cover 100 shares each, so a quoted premium of $3.00 means $300 of real cash per contract.
In practice
Real-world examples.
Example
A regional airline buys call options on jet fuel with a strike equivalent to $85 a barrel. Fuel rises to $110, the options pay out, and the gain offsets most of the extra cost at the pump, which is exactly what the hedge was for.
Example
A startup employee is granted options over 10,000 shares at a $2.00 strike price, vesting over four years. When the company is later valued at $9.00 a share, exercising costs $20,000 and delivers shares worth $90,000.
Example
A fund manager holding a large position in a bank buys put options with a $40 strike ahead of a regulatory decision. The shares fall to $31, and the puts recover a large part of the loss on the shares themselves.
Think of it
“Options contract is an agreement for the right to trade-not the obligation, just the option.
Formula
Calculation
Profit on a bought call at expiry = (share price at expiry - strike price - premium paid) x contract size
An investor buys one call option on a retailer's shares with a strike price of $50, expiring in three months, at a premium of $3.00 per share. One contract covers 100 shares, so the cash outlay is $3.00 x 100 = $300.
By expiry the shares have risen to $58. The option is worth $58 - $50 = $8.00 per share, so exercising and selling produces $8.00 x 100 = $800, and the profit after the premium is $800 - $300 = $500.
The breakeven price was $50 + $3.00 = $53. Anywhere below $53 the trade loses money, and at or below $50 the option expires worthless and the whole $300 premium is gone.Case study
Seen in the real world.
Selkirk Coffee Roasters is a fictional importer created to illustrate how a business uses options rather than futures. It needed to protect against a rise in green coffee prices but did not want to be locked in if prices fell, which is what a futures contract would have done.
In the illustrative scenario, Selkirk bought call options covering 500,000 pounds of coffee at a strike of $1.80 a pound, paying a premium of $0.09 a pound, or $45,000 in total. Prices then fell to $1.55, so the options expired worthless and the $45,000 was lost.
Selkirk's buyers, though, purchased coffee in the open market at $1.55 rather than being locked into $1.80, saving $125,000 against the strike price. The fictional example shows the trade-off plainly: the premium is the price of keeping the upside, and in a falling market it behaves exactly like an insurance premium on a policy you did not need to claim.
Watch out
Common mistakes.
- Believing the buyer must exercise the option. The whole point is that exercising is a choice, and most options are sold on or left to expire instead.
- Reading a quoted premium as the total cost. Premiums are quoted per share, so a standard contract multiplies that figure by 100.
- Assuming selling options is a safe way to earn income. Uncovered sellers face losses far larger than the premium collected if the market moves against them.
Questions
People also ask.
What is the difference between a call and a put?
A call is the right to buy at the strike price, and a put is the right to sell at it, so calls gain when prices rise and puts gain when they fall.
What does in the money mean?
It means exercising would be worth something today, which for a call means the share price is above the strike price.
Can I lose more than I paid?
As a buyer, no, your loss is capped at the premium; as a seller of an uncovered option, yes, and potentially by a great deal.
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