What Is an Option?

Many of the highest paying funds on the market today are really options strategies dressed up as income funds. To understand them, and to judge whether their yields are worth the risk, you need to know what an option is. Don’t worry: you don’t need any maths beyond multiplication, and we’ll start from absolute zero.

An option is a contract

An option is an agreement between two people about a stock. One side pays money for a right. The other side takes the money and accepts an obligation. That’s it. Every option has the same four parts:

In the US, one standard option contract covers 100 shares. Premiums are quoted per share, so a premium of $1.50 means the contract costs $150.

Calls: the right to buy

A call gives its buyer the right to buy 100 shares at the strike price, any time before it expires. Think of it like paying a deposit to hold a house at an agreed price: if house prices rise, your deposit locks in a bargain; if they fall, you walk away and lose only the deposit.

The seller of that call took your $150 and agreed to sell you 100 shares at $50 if you ask. If the stock stays below $50, they keep the $150 and nothing else happens.

Puts: the right to sell

A put gives its buyer the right to sell 100 shares at the strike price before expiration. It works like insurance: you pay a premium, and if the stock falls below the strike, the put pays off.

The seller of the put collected $100 and agreed to buy your shares at $45 if you want to sell. That’s exactly the trade behind the cash-secured put strategy in Cash-Secured Puts.

Rights vs obligations

Buyers pay a small amount for a chance at a big payoff. Sellers collect a small, certain amount and take on the risk of a big move. Income strategies, and income funds, sit on the seller’s side.

In, at and out of the money

• A call is in the money when the stock is above the strike (the right to buy cheaply is worth something), and out of the money when it’s below.
• A put is in the money when the stock is below the strike, and out of the money when it’s above.
• At the money means the stock is right at the strike.

Out of the money options are cheaper because they need the stock to move before they’re worth anything at expiration. You’ll see why that matters for covered call funds in Covered Call ETF Strategies Compared.

See every payoff

Pick a position below and watch the profit or loss at expiration change with the stock price. Notice how buying and selling the same option are perfect mirror images: every dollar one side makes, the other loses.

What happens at expiration

At expiration, an in the money option is normally exercised: the shares change hands at the strike. When the buyer exercises, the seller is assigned and must deliver or buy the shares. Out of the money options simply expire worthless and the seller keeps the premium.

Options on individual US stocks and ETFs are “American style”: they can be exercised any day before expiration, not just at the end. Options on indexes like the S&P 500 are usually “European style”: exercisable only at expiration and settled in cash, with no shares changing hands. That difference, and how index options are taxed, comes up again in Section 1256 and the 60/40 Rule.

To trade options yourself, your broker will ask you to apply for options approval and assign you a level. Covered calls and cash-secured puts usually need only the lowest levels. Next, we look at what makes an option cheap or expensive in How Options Are Priced.