> **Definition**
>
> An option is a type of financial instrument that's tied to an underlying security. Options give their buyers the right, but not the obligation, to purchase or sell the asset at a specified price.

## What Are Options?

Options are versatile [financial instruments](https://www.investopedia.com/terms/f/financialinstrument.asp) that derive their value from an underlying security, such as stocks, [indexes, and exchange-traded funds (ETFs)](https://www.investopedia.com/articles/optioninvestor/10/etf-options-v-index-options.asp). Unlike futures contracts, options offer buyers the right—but not the obligation—to buy or sell the underlying asset at a predetermined strike price within a specific time frame. This flexibility allows investors to leverage positions without committing to purchase or sell, providing a strategic tool for speculation and hedging against market fluctuations.

Options are commonly traded through [online platforms or retail brokers](https://www.investopedia.com/the-best-brokers-for-options-trading-8763492), with each contract having a predetermined expiration date that dictates when the options must be exercised.  

### Key Takeaways

*   Options are financial instruments that provide the right, but not the obligation, to buy or sell an underlying asset at a set strike price, offering investors a way to leverage their positions or hedge against risks.
*   The two main types of options are call options, which benefit from an increase in the underlying asset's price, and put options, which profit from a decline in the asset's price.
*   Options are categorized as American or European based on their exercise timings, not geography; American options can be exercised anytime before expiration, while European options can only be exercised at expiration.
*   "The Greeks" are crucial risk metrics in options trading—with delta measuring price sensitivity, theta representing time decay, gamma showing delta fluctuation, and vega indicating volatility sensitivity.
*   Options strategies, such as spreads, use combinations of buying and selling different options to achieve specific risk-return profiles, enabling traders to capitalize on various market scenarios, including volatility and price movements.

![Option](https://www.investopedia.com/thmb/LAUIBWrnhggDZR706cTXEY4To2o=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Option-fe0c0ee9204c4a50a281e728fb4c7cab-c571c7af929e4b8587c5a28ad9905f53.jpg)

*Call option writers face near-infinite risk, as a stock’s price can continuously rise. — Investopedia / Michela Buttignol*

## How Options Work

Options are versatile financial products. These contracts involve a buyer and seller, where the buyer pays a premium for the rights granted by the contract. [Call options](https://www.investopedia.com/terms/c/call.asp) allow the holder to buy the asset at a stated price within a specific time frame. [Put options](https://www.investopedia.com/terms/p/put.asp), on the other hand, allow the holder to sell the asset at a stated price within a specific time frame. Each call option has a bullish buyer and a bearish seller, while put options have a bearish buyer and a bullish seller.

Traders and investors buy and sell options for several reasons. Options allow traders to leverage a position in an asset for less cost than buying the shares directly. Investors use options to hedge or reduce the risk exposure of their portfolios.

In some cases, the option holder can generate income when they buy call options or become an options writer. Options are also one of the most direct ways to invest in oil. For options traders, an option's daily trading volume and open interest are the two key numbers to watch to make the most well-informed investment decisions.

American options can be exercised any time before expiration, whereas European options can only be exercised at expiration. Exercising means utilizing the right to buy or sell the underlying security.

### Options Terminology to Know

Options trading involves a lot of lingo. Here are just some of the key terms to know the meanings of:

*   [**At-the-money (ATM)**](https://www.investopedia.com/terms/a/atthemoney.asp): An option whose strike price is exactly that of where the underlying is trading. ATM options have a delta of 0.50.
*   [**In-the-money (ITM)**](https://www.investopedia.com/terms/i/inthemoney.asp): An option with intrinsic value and a delta greater than 0.50. For a call, the strike price of an ITM option will be below the current price of the underlying; for a put, it'll be above the current price.
*   [**Out-of-the-money (OTM)**](https://www.investopedia.com/terms/o/outofthemoney.asp): An option with only extrinsic (time) value and a delta a less than 0.50. For a call, the strike price of an OTM option will be above the current price of the underlying; for a put, it'll be below the current price.
*   [**Premium**](https://www.investopedia.com/terms/o/option-premium.asp): The price paid for an option in the market.
*   [**Strike price**](https://www.investopedia.com/terms/s/strikeprice.asp): The price at which you can buy or sell the underlying, also known as the exercise price.
*   [**Underlying**](https://www.investopedia.com/terms/u/underlying-security.asp): The security upon which the option is based.
*   [**Implied volatility (IV)**](https://www.investopedia.com/terms/i/iv.asp): The volatility of the underlying (how quickly and severely it moves) as revealed by market prices.
*   [**Exercise**](https://www.investopedia.com/terms/e/exercise.asp): When an options contract owner exercises the right to buy or sell at the strike price. The seller is then said to be [assigned](https://www.investopedia.com/terms/a/assignment.asp).
*   [**Expiration**](https://www.investopedia.com/terms/e/expirationdate.asp): The date at which the options contract expires, or ceases to exist. OTM options will expire worthless.

## Exploring the Types of Options: Calls and Puts

### Calls

A call option gives the holder the right, but not the obligation, to buy the underlying stock at the strike price on or before expiration. A call option will therefore become more valuable as the underlying security rises in price (calls have a positive delta).

A long call can be used to speculate on the price of the underlying rising, as it has unlimited upside potential and a maximum loss equal to the premium (price) paid for the option.

### Puts

Opposite to call options, a put gives the holder the right, but not the obligation, to sell the underlying stock at the strike price on or before expiration. A long put, therefore, is a short position in the underlying security, as the put gains value as the underlying's price falls (puts have a negative delta).

[Protective puts](https://www.investopedia.com/terms/p/protective-put.asp) can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions.

## Understanding American and European Option Styles

[American options](https://www.investopedia.com/terms/a/americanoption.asp) can be exercised at any time between the date of purchase and the expiration date. [European options](https://www.investopedia.com/terms/e/europeanoption.asp) are different from American options in that they can only be exercised at the end of their lives on their expiration date.

The difference between [American and European options](https://www.investopedia.com/articles/optioninvestor/08/american-european-options.asp) is about early exercise, not geography. In the United States, most single stock options are American while index options are European. An American option also typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.

## Key Considerations for Trading Options

Each [options contract](https://www.investopedia.com/terms/o/optionscontract.asp) usually represents 100 shares of the underlying asset. The buyer pays a premium fee for each contract. For example, if an option has a premium of 35 cents per contract, buying one option costs $35 ($0.35 x 100). The premium is partially based on the strike price.

Another factor in the premium price is the [expiration date](https://www.investopedia.com/terms/e/expirationdate.asp). Just like with that carton of milk in the refrigerator, the expiration date indicates the day the option contract must be used. The underlying asset will influence the use-by date and some options will expire daily, weekly, monthly, and even quarterly. For monthly contracts, it's usually the third Friday.

### Strategies With Options Spreads

Options spreads combine buying and selling different options to achieve a specific risk-return profile. Spreads are constructed using [vanilla options](https://www.investopedia.com/terms/v/vanillaoption.asp) and can take advantage of various scenarios, such as high- or low-volatility environments, up- or down-moves, or anything in-between.

> **Important**
>
> Spread strategies can be characterized by their payoff or visualizations of their profit-loss profile, such as bull call spreads or iron condors.

## Decoding the Greeks: Key Metrics for Options Risk Management

The options market uses the term the "[Greeks](https://www.investopedia.com/terms/g/greeks.asp)" to describe the different dimensions of [risk involved in taking an options position](https://www.investopedia.com/ask/answers/032415/why-are-call-and-put-options-considered-risky.asp), either in a particular option or a portfolio. These variables are called Greeks because they're typically associated with Greek symbols.

Each risk variable is a result of an imperfect assumption or relationship of the option with another underlying variable. Traders use different Greek values to assess options [risk](https://www.investopedia.com/terms/r/risk.asp) and manage option portfolios.

### Delta

[Delta](https://www.investopedia.com/terms/d/delta.asp) (Δ) represents the [rate of change](https://www.investopedia.com/terms/r/rateofchange.asp) between the option's price and a $1 change in the [underlying asset's](https://www.investopedia.com/terms/u/underlying-asset.asp) price. In other words, the price sensitivity of the option relative to the underlying. Delta of a call option has a range between zero and one, while the delta of a [put option](https://www.investopedia.com/terms/p/putoption.asp) has a range between zero and negative one. For example, let's assume an investor is long a call option with a delta of 0.50. Therefore, if the underlying stock increases by $1, the option's price would theoretically increase by 50 cents.

Delta also indicates the [hedge ratio](https://www.investopedia.com/terms/h/hedgeratio.asp) needed for a [delta-neutral](https://www.investopedia.com/terms/d/deltaneutral.asp) position. So if you purchase a standard American call option with a 0.40 delta, you need to sell 40 shares of stock to be fully hedged. Net delta for a portfolio of options can also be used to obtain the portfolio's hedge ratio.

A [less common usage of an option's delta](https://www.investopedia.com/articles/optioninvestor/03/021403.asp) is the current probability that it'll expire ITM. For instance, a 0.40 delta call option today has an implied 40% probability of finishing ITM.

### Theta

[Theta](https://www.investopedia.com/terms/t/theta.asp) (Θ) represents the rate of change between the option price and time, or time sensitivity—sometimes known as an option's time decay. Theta indicates the amount an option's price would decrease as the time to expiration decreases, all else equal. For example, assume an investor is long an option with a theta of -0.50. The option's price would decrease by 50 cents every day that passes, all else being equal. If three trading days pass, the option's value would theoretically decrease by $1.50.

Theta is higher for ATM options and lower for ITM or OTM options. Options closer to expiration also have accelerating time decay. Long calls and long puts usually have negative Theta. Short calls and short puts, on the other hand, have positive Theta. By comparison, an instrument whose value isn't eroded by time has zero Theta.

### Gamma

[Gamma](https://www.investopedia.com/terms/g/gamma.asp) (Γ) represents the rate of change between an option's delta and the underlying asset's price. This is called second-order (second-derivative) price sensitivity. Gamma indicates the amount the delta would change given a $1 move in the underlying security. Let's assume an investor is long one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ increases or decreases by $1, the call option's delta would increase or decrease by 0.10.

Gamma is used to determine the stability of an option's delta. Higher gamma values indicate that delta could change dramatically in response to even small movements in the underlying's price.

Gamma is higher for ATM options and lower for ITM or OTM options, increasing as expiration nears. Gamma values are generally smaller the further away from the date of expiration. This means that options with longer expirations are less sensitive to delta changes. As expiration approaches, gamma values are typically larger, as price changes have more impact on gamma.

Options traders may opt to not only hedge delta but also gamma in order to be [delta-gamma neutral](https://www.investopedia.com/terms/d/deltagamma-hedging.asp), meaning that as the underlying price moves, the delta will remain close to zero.

### Vega

[Vega](https://www.investopedia.com/terms/v/vega.asp) (V) represents the rate of change between an option's value and the underlying asset's IV. This is the option's sensitivity to volatility. Vega indicates the amount an option's price changes given a 1% change in IV. For example, an option with a vega of 0.10 indicates the option's value is expected to change by 10 cents if the IV changes by 1%.

Because increased volatility implies that the underlying instrument is more likely to experience extreme [values](https://www.investopedia.com/terms/v/value.asp), a rise in volatility correspondingly increases the value of an option. Conversely, a decrease in volatility negatively affects the value of the option. Vega is at its maximum for ATM options that have longer times until expiration.

Those familiar with the Greek alphabet will point out that there's no actual Greek letter named vega. There are various theories about how this symbol, which resembles the Greek letter nu, found its way into stock-trading lingo.

### Rho

[Rho](https://www.investopedia.com/terms/r/rho.asp) (p) represents the rate of change between an option's value and a 1% change in the [interest rate](https://www.investopedia.com/terms/i/interestrate.asp). This measures sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options. Rho is greatest for ATM options with long times until expiration.

### Minor Greeks

Some other Greeks, which aren't discussed as often, are [lambda](https://www.investopedia.com/terms/l/lambda.asp), epsilon, [vomma](https://www.investopedia.com/terms/v/vomma.asp), vera, speed, [zomma](https://www.investopedia.com/terms/z/zomma.asp), color, and ultima.

These Greeks are second- or third-derivatives of the pricing model and affect things like the change in delta with a change in volatility. They're increasingly used in options trading strategies, as computer software can quickly compute and account for these complex and sometimes esoteric risk factors.

## Weighing the Pros and Cons of Options Trading

### Buying Call Options

As mentioned earlier, call options allow the holder to buy an underlying security at the stated strike price by the expiration date, also called the expiry. The holder has no obligation to buy the asset if they don't want to purchase the asset. The risk to the buyer is limited to the premium paid. Fluctuations of the underlying stock have no impact.

Suppose buyers are bullish on a stock and believe the share price will rise above the strike price before the option expires. If the investor's bullish outlook is realized and the price increases above the strike price, the investor can exercise the option, buy the stock at the strike price, and immediately sell the stock at the current market price for a profit.

Their profit on this trade is equal to the market share price less the strike share price, plus the expense of the option (the premium and any brokerage commission to place the orders). The result is multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 [shares](https://www.investopedia.com/terms/s/shares.asp).

If the underlying stock price doesn't move above the strike price by the expiration date, the option expires worthlessly. The holder isn't required to buy the shares but will lose the premium paid for the call.

### Selling Call Options

Selling call options is known as writing a contract. The writer receives the premium fee. In other words, a buyer pays the premium to the writer (seller) of an option. The maximum profit is the premium received when selling the option. The seller of a call option expects the stock price to fall or stay near the strike price.

If the prevailing market share price is at or below the strike price by expiry, the option expires worthlessly for the call buyer. The option seller pockets the premium as their profit. The option isn't exercised because the buyer wouldn't buy the stock at the strike price higher than or equal to the prevailing [market price](https://www.investopedia.com/terms/m/market-price.asp).

However, if the market share price is more than the strike price at expiry, the seller of the option must sell the shares to an option buyer at that lower strike price. In other words, the seller must either sell shares from their [portfolio](https://www.investopedia.com/terms/p/portfolio.asp) holdings or buy the stock at the prevailing market price to sell to the call option buyer. The contract writer incurs a loss. How large of a loss depends on the cost basis of the shares they must use to cover the option order plus any brokerage order [expenses](https://www.investopedia.com/terms/e/expense.asp), less any premium they received.

As you can see, the risk to the [call writers](https://www.investopedia.com/terms/w/writing-an-option.asp) is far greater than the risk exposure of call buyers. The call buyer only loses the premium. The writer faces infinite risk because the stock price could continue to rise, increasing losses significantly.

### Buying Put Options

Put options are investments where the buyer believes the underlying stock's market price will fall below the strike price on or before the expiration date of the option. Once again, the holder can sell shares without the obligation to sell at the stated strike per share price by the stated date.

Since buyers of put options want the stock price to decrease, the put option is profitable when the underlying stock's price is below the strike price. If the prevailing market price is less than the strike price at expiry, the investor can exercise the put. They'll sell shares at the option's higher strike price. Should they wish to replace their holding of these shares, they may buy them on the open market.

Their profit on this [trade](https://www.investopedia.com/terms/t/trade.asp) is equal to the strike price less the current market price, plus expenses (the premium and any brokerage commission to place the orders). The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.

The value of holding a put option will increase as the underlying stock price decreases. Conversely, the value of the put option declines as the stock price increases. The risk of buying put options is limited to the loss of the premium if the option expires worthlessly.

### Selling Put Options

Selling put options is also known as writing a contract. A put option writer believes the underlying stock's price will stay the same or increase over the life of the option, making them bullish on the shares. Here, the option buyer has the right to make the seller buy shares of the underlying asset at the strike price on expiry.

If the underlying stock's price closes above the strike price by the expiration date, the put option expires worthlessly. The writer's maximum profit is the premium. The option isn't exercised because the option buyer wouldn't sell the stock at the lower strike share price when the market price is higher.

If the stock's market value falls below the option strike price, the writer is obligated to buy shares of the underlying stock at the strike price. In other words, the put option will be exercised by the option buyer who sells their shares at the strike price because it's higher than the stock's market value.

A put option writer risks losing when the market price drops below the strike price. The seller is then forced to purchase shares at the strike price at expiration. The writer's loss can be significant depending on how much the shares depreciate.

The writer (seller) can either hold on to the shares and hope the stock price rises back above the purchase price or sell the shares and take the loss. Any loss is offset by the premium received.

An investor may write put options at a strike price where they see the shares being a good value and would be willing to buy at that price. When the price falls and the buyer exercises their option, they get the stock at the price they want with the added benefit of receiving the option premium.

Pros

*   A call option buyer has the right to buy assets at a lower price than the market when the stock's price rises
    
*   The put option buyer profits by selling stock at the strike price when the market price is below the strike price
    
*   Option sellers receive a premium fee from the buyer for writing an option
    

Cons

*   The put option seller may have to buy the asset at a higher strike price than they would normally pay if the market falls
    
*   The call option writer faces infinite risk if the stock's price rises and they're forced to buy shares at a high price
    
*   Option buyers must pay an upfront premium to the writers of the option
    

## Example of an Option

Suppose that Microsoft ([MFST](https://www.investopedia.com/markets/quote?tvwidgetsymbol=msft)) shares trade at $508 per share and you believe they'll increase in value. You decide to buy a call option to benefit from an increase in the stock's price. You purchase one call option with a strike price of $515 for one month in the future for 37 cents per contract. Your total cash outlay is $37 for the position plus fees and commissions (0.37 x 100 = $37).

If the stock rises to $516, your option will be worth $1, as you could exercise the option to acquire the stock for $515 per share and immediately resell it for $516 per share. The profit on the option position would be 170.3% since you paid 37 cents and earned $1—that's much higher than the 7.4% increase in the underlying stock price from $508 to $516 at the time of expiry.

In other words, the profit in dollar terms would be a net of 63 cents, or $63, as one option contract represents 100 shares \[($1 - 0.37) x 100\].

If the stock fell to $500, your option would expire worthlessly, and you would be out $37 premium. The upside is that you didn't buy 100 shares at $508, which would have resulted in an $8 per share, or $800, total loss. As you can see, options can help limit your downside risk.

## What Are the Main Advantages of Options?

Options can be very useful as a source of leverage and risk hedging.

For example, a bullish investor who wishes to invest $1,000 in a company could potentially earn a far greater return by purchasing $1,000 worth of call options on that firm, compared to buying $1,000 of that company’s shares. In this sense, the call options provide the investor with a way to leverage their position by increasing their buying power.

On the other hand, if that same investor already has exposure to that same company and wants to reduce that exposure, they could hedge their risk by selling put options against that company.

## What Are the Main Disadvantages of Options?

The main disadvantage of options contracts is that they're complex and difficult to price. This is why options are considered to be most suitable for experienced professional investors. In recent years, they've become increasingly popular among retail investors. Because of their capacity for outsized returns or losses, investors should make sure they fully understand the potential implications before entering into any options positions. Failing to do so can lead to devastating losses.

## How Do Options Differ From Futures?

Both [options and futures](https://www.investopedia.com/ask/answers/072915/how-does-forward-contract-differ-call-option.asp) are types of derivatives contracts that are based on some underlying asset or security. The main difference is that options contracts grant the right, but not the obligation, to buy or sell the underlying in the future. [Futures contracts](https://www.investopedia.com/terms/f/futurescontract.asp), meanwhile, come with an obligation to buy or sell the underlying.

## Is an Options Contract an Asset?

An options contract is a derivatives security, which is a type of asset.

## The Bottom Line

Options are a type of derivative product that allow investors to speculate on or hedge against the volatility of an underlying stock. Options are divided into call options, which allow buyers to profit if the price of the stock increases, and put options, in which the buyer profits if the price of the stock declines. Investors can also short an option by selling them to other investors. Shorting (selling) a call option would therefore mean profiting if the underlying stock declines, while selling a put option would mean profiting if the stock increases in value.

> **Article Sources**
>
> 1.  U.S. Securities and Exchange Commission. "[Investor Bulletin: An Introduction to Options](https://www.sec.gov/oiea/investor-alerts-bulletins/ib_introductionoptions)."
>     
> 2.  CME Group Education. "[Understanding the Difference: European vs. American Style Options](https://www.cmegroup.com/education/courses/introduction-to-options/understanding-the-difference-european-vs-american-style-options.html)."
>     
> 3.  The Options Industry Council. "[Delta](https://www.optionseducation.org/advancedconcepts/delta)."
>     
> 4.  FINRA. "[Options: Types](https://www.finra.org/investors/investing/investment-products/options#types)."
>     
> 5.  CME Group Education. "[What is Expiration Date (Expiry)?](https://www.cmegroup.com/education/courses/introduction-to-options/what-is-expiration-date-expiry.html)"
>     
> 6.  The Options Industry Council. "[Volatility & the Greeks](https://www.optionseducation.org/advancedconcepts/volatility-the-greeks)."
>     
> 7.  CME Group Education. "[Options Delta - The Greeks](https://www.cmegroup.com/education/courses/option-greeks/options-delta-the-greeks.html)."
>     
> 8.  The Options Industry Council. "[Theta](https://www.optionseducation.org/advancedconcepts/theta)."
>     
> 9.  The Options Industry Council. "[Gamma](https://www.optionseducation.org/advancedconcepts/gamma)."
>     
> 10.  Northwestern University: McCormick School of Engineering. "[Math Lab: Constructing Greek-Neutral Portfolios of European Stock Options](http://www.ece.northwestern.edu/local-apps/matlabhelp/toolbox/finance/samples5.html)."
>      
> 11.  The Options Industry Council. "[Vega](https://www.optionseducation.org/advancedconcepts/vega)."
>      
> 12.  CME Group Education. "[Options Vega - The Greeks](https://www.cmegroup.com/education/courses/option-greeks/options-vega-the-greeks.html)."
>      
> 13.  The Options Industry Council. "[Rho](https://www.optionseducation.org/advancedconcepts/rho)."
>      
> 14.  FINRA. "[Options: Buying and Selling](https://www.finra.org/investors/investing/investment-products/options#buying-and-selling)."