Chapter 1: Introduction

What is an option

Options are contracts that convert uncertainty into defined choices. Instead of forcing you to transact, an option grants you a decision point later: you may buy or sell a specified asset at a preset price, or you can walk away if conditions aren’t favorable. That asymmetry—choice without obligation—is why options serve two very different purposes. Risk-averse investors use them to cap losses or lock in targets, much like insurance. Opportunistic traders use them to pursue returns from directional moves, volatility shifts, or time decay. Either way, an option’s worth is tethered to something else—a stock, ETF, index, or future—yet its behavior isn’t a one-for-one mirror of that underlying. Time to expiration, expected volatility, interest rates, dividends, and the strike relationship all shape how an option responds.

Because of that, options can add precision to a portfolio. They can soften drawdowns, define risk on new ideas, generate income, or amplify exposure with less capital than owning shares outright. But they also come with their own language and workflow: strikes and expirations, exercise and assignment, greeks and implied volatility, order types and fills. Mastery starts with clear foundations and builds toward how the market actually operates and how prices are formed. Because the holder is not forced to act, the option only matters when it is advantageous to do so. If conditions make it unprofitable, the contract simply expires. In this sense, options are different from owning stock or bonds directly—they provide flexibility without mandatory commitment.

Options are part of a larger category of instruments called derivatives. A derivative’s value is tied to something else, known as the underlying asset. On modern exchanges, that underlying is often a stock or commodity, though it can also be a market index, an interest rate, or even a measure of volatility. In contract law, the underlying could be virtually anything of agreed value.

The use of option-like clauses predates modern finance. Consider real estate: if you want to purchase a new home but need time to sell your current one, you might include a clause giving you the ability to walk away if your existing house does not sell. You have the right, but not the obligation, to proceed. The seller, however, will likely require compensation for granting that flexibility—often in the form of a cash payment. This payment functions as the premium of the option.

The Modern Options Market

Although informal uses of options existed for centuries, standardized trading didn’t begin until 1973, when the Chicago Board Options Exchange (CBOE) was launched. With standardized terms for strike prices, expiration dates, and contract sizes, options became accessible to anyone willing to trade them. This innovation transformed them from custom agreements into widely traded financial instruments.

Why Options Exist

Options serve three major purposes in markets: insurance, leverage, and speculation.

Insurance

One of the most important uses of options is risk protection. Investors frequently want to lock in the ability to buy or sell at a certain price, especially when managing positions they already hold. Paying a premium for this flexibility is similar to buying insurance. The process of using options to protect against adverse market moves is called hedging. A trader who hedges is sacrificing a small, known cost to avoid potentially larger, unpredictable losses.

Leverage

Another defining feature of options is leverage. Leverage means generating returns that are proportionally larger than the amount of capital invested. In engineering terms, a lever lets you move something heavy with relatively little force. In finance, options achieve the same effect.

Let’s take an example. Suppose Microsoft stock trades at $277.73. You could buy shares directly, or you could purchase a call option with a strike price of $297.50, costing $4.70 per share in premium. If Microsoft rises modestly, the stockholder benefits directly. But once the stock surpasses $302.20 (strike plus premium), the option holder begins earning profits. At $310 per share, the stock buyer has gained about 11.9%, but the option holder earns a return of over 160% on the premium paid.

This shows how a smaller upfront cost can create outsized percentage returns. Of course, leverage cuts both ways. If the stock falls sharply—to $240, for instance—the shareholder faces a sizable loss, while the option buyer loses only the premium. The trade-off is clear: options require less capital but come with the possibility of total loss if the option expires worthless.

Speculation

Because of their leverage, options are attractive to speculators—those who trade purely to profit from price movements. These traders are not necessarily seeking protection; instead, they are drawn to the possibility of turning small investments into large returns. While risk is always present, the potential rewards keep speculation active and vibrant.

Speculators play an important role in the ecosystem. Alongside hedgers, they ensure markets remain liquid and efficient. Exchanges design their products with both groups in mind. A healthy mix of hedgers and speculators keeps demand strong, maintains fair pricing, and provides valuable insight into how participants view the future of the market.