Options: calls and puts
An option is the right to buy or sell something at a set price. The buyer pays a premium for it. The seller takes on an obligation.
A call gives you the right to buy something at a fixed price. If the price rises above it, that right is worth something. A put gives you the right to sell, and becomes valuable if the price falls.
You pay a premium for that right. If nothing happens, the option expires and the premium is gone. Your loss is therefore capped at what you paid.
On the other side sits whoever sold the option. They collect the premium and carry the obligation in exchange. That side has capped gains and potentially very large losses.
Important starting point: an option's value depends not just on the price, but also on time remaining and expected volatility. You can call the direction right and still lose, because time is working against you.
An option's value splits into intrinsic value and time value. Intrinsic value is the amount realizable immediately; time value reflects the probability of future favorable moves. Time value decays to zero by expiration, with the decay accelerating toward the end of the term.
Valuation factors are described through sensitivity metrics: delta as the reaction to the underlying, gamma as the rate of change of delta, theta as time-value loss per day, vega as the reaction to expected volatility, and rho as interest-rate sensitivity. A position can lose money even with the right directional call, if theta and vega work against it.
Central to all this is implied volatility, meaning the volatility expectation that explains the observed option price within the valuation model. It's the actual tradable quantity in the options market. Buying options at high implied volatility can be a losing trade even with a correct directional forecast, if that expectation subsequently falls.
Summary
- Buyers have capped losses, sellers have capped gains.
- Time value decays and accelerates toward the end of the term.
- You can lose money on the right call if volatility expectations fall.
Did you get it?
What makes up an option's price?
Intrinsic value and time value. Time value falls to zero by expiration.
What does theta measure?
The time-value loss per day.
What is implied volatility?
The volatility expectation that explains the observed option price. It's the actual tradable quantity.