The right, not the obligation
A forward obligates both parties — they must trade at expiration. An option is different: it gives the holder the right, but not the obligation, to make a trade. The buyer of the option pays a price (premium) for that right; the seller (writer) collects the premium and takes on the obligation.
Two flavors:
- Call option: the right to buy the underlying at a pre-set price (the strike) on or before the expiration date.
- Put option: the right to sell the underlying at the strike price on or before expiration.
The buyer (long the option) chooses whether to exercise. They'll exercise only if it's profitable. Otherwise the option expires worthless and they lose only the premium they paid.
A simple call example
A stock trades at ₩50. You buy a 3-month call option with strike ₩55, paying a premium of ₩2.
Three months later:
- Stock is at ₩60. You exercise: buy at ₩55, immediately worth ₩60. Gain ₩5/share, minus the ₩2 premium = ₩3/share net profit.
- Stock is at ₩50. The option is worthless — why exercise the right to buy at ₩55 when you can buy at ₩50 in the open market? Option expires unused. You lose the ₩2 premium.
- Stock is at ₩40. Same as above — option worthless. You lose ₩2.
Notice the asymmetry. Upside is open-ended (stock could go to ₩100, ₩200, profit grows linearly). Downside is capped at the premium (₩2). This asymmetric payoff is the magic of options.
Strike, expiration, premium — the three numbers that define an option
- Strike price: the agreed-upon trade price.
- Expiration: when the right ends. Could be days (weeklies), weeks, months, or years (LEAPS).
- Premium: what the buyer pays to acquire the option, set by the market.
The premium is the price of the option. It depends on a lot of things — the strike vs. current price, time to expiration, volatility (lesson 8-4), interest rates, dividends. Lesson 8-5 (Black-Scholes) is the formal pricing model. For now: premium reflects the option's expected payoff plus a "time value" for the chance of bigger payoffs.
In/at/out of the money
- In-the-money (ITM): exercising right now would be profitable. Call: stock above strike. Put: stock below strike.
- At-the-money (ATM): stock ≈ strike.
- Out-of-the-money (OTM): exercising would be unprofitable. Call: stock below strike. Put: stock above strike.
OTM options can still be valuable — they're "lottery tickets" that pay off if the stock moves enough. Many options strategies revolve around how much you pay for OTM options vs. how often they actually pay off.
The takeaway
Option = right (not obligation) to trade an underlying at a strike price by an expiration date. Calls = right to buy. Puts = right to sell. Buyer pays premium; seller collects it. Asymmetric payoff: capped downside, open-ended upside. Three defining numbers: strike, expiration, premium. ITM/ATM/OTM describes the relationship between current price and strike. Lessons 8-3 and 8-4 explore payoffs and intuition; 8-5 the math.