What Are Options?
Understand the fundamentals of options contracts, how they differ from stocks, and why traders use them for income and hedging.
By Jin, founder of Wheel Strategy Options
What Are Options?
An option is a contract that gives you the right, but not the obligation, to buy or sell a stock at a specific price before a certain date. Unlike stocks, where you own a piece of a company, options are derivatives - their value is derived from an underlying stock.
Options vs. Stocks
| Aspect | Stocks | Options |
|---|---|---|
| Ownership | Own part of a company | Own a contract (right to buy/sell) |
| Expiration | Never expire | Expire on a specific date |
| Price Movement | 1:1 with market | Leveraged, can move more or less |
| Income Potential | Dividends only | Premium from selling options |
| Risk | Can lose investment | Can lose premium or more |
Why Trade Options?
Traders use options for several key reasons:
1. Generate Income Selling options (like in the wheel strategy) creates premium income. This is like being paid to agree to buy or sell a stock at a specific price.
2. Leverage Options let you control 100 shares with less capital than buying the shares outright. A $50 stock costs $5,000 for 100 shares, but an option might cost just $150.
3. Hedging Options can protect your portfolio. Buying puts on stocks you own is like insurance against a drop in price.
4. Flexibility You can profit whether stocks go up, down, or sideways - depending on your strategy.
The Two Types of Options
Call Options
- Give you the right to buy 100 shares at the strike price
- Buyers want the stock to go UP
- Sellers want the stock to stay flat or go DOWN
Put Options
- Give you the right to sell 100 shares at the strike price
- Buyers want the stock to go DOWN
- Sellers want the stock to stay flat or go UP
Key Terms You Need to Know
| Term | Definition |
|---|---|
| Strike Price | The price at which you can buy/sell the stock |
| Premium | The price of the option contract |
| Expiration Date | When the option contract ends |
| Underlying | The stock the option is based on |
| Contract | Each option controls 100 shares |
Example: A Simple Call Option
Let's say Apple (AAPL) is trading at $175:
- You buy a $180 call option for $3
- This costs you $300 total (100 shares × $3)
- You have the right to buy 100 shares at $180 until expiration
If AAPL rises to $190:
- Your call is worth at least $10 ($190 - $180)
- Your $300 investment is now worth $1,000+
- Profit: $700+
If AAPL stays below $180:
- Your call expires worthless
- You lose your $300 premium
The Wheel Strategy Approach
In the wheel strategy, we focus on selling options rather than buying them:
- Selling puts = Getting paid to potentially buy a stock at a lower price
- Selling calls = Getting paid to potentially sell a stock at a higher price
This shifts the odds in our favor because most options expire worthless - and when you're the seller, that means you keep the premium.
In the next lesson, we'll dive deeper into how options work mechanically.