Options for Beginners Part 2

Calls and puts

As explained in the previous lesson, an options grants you the right to buy or sell an asset at a specific price within a timeframe. There are two types of options: calls and puts. A call gives you the right to buy while the put gives you the right to sell. You buy calls when you anticipated the price of the underlying asset to go up while you buy a put when you anticipate the price of the underlying asset to go down. If you think XYZ stock is going to rise 5% in the coming week, you can buy call options. If you expect it to fall 5%, you would buy put options. Option contracts generally give you the right to buy/short 100 shares per contract.

Bid and Ask

Every security that trades in the market—stocks as well as options—has two quoted prices: the bid and the ask. The bid represents the maximum price a buyer, often a broker or market maker, is prepared to pay to acquire the security. The ask, on the other hand, reflects the lowest price at which a seller, again usually a broker or market maker, is willing to part with it. The space between these two figures is known as the bid–ask spread. That spread effectively serves as compensation for the market maker, who assumes the risk of holding inventory and facilitating trades.

The bid–ask spread is more than just a transactional detail—it also communicates valuable information about the market. A tight spread, where the difference between bid and ask is small, indicates that the option is actively traded and that liquidity is high. In such an environment, traders can enter and exit positions with relative ease and minimal additional cost. Conversely, a widespread suggests low activity and reduced liquidity, making trades more expensive and potentially harder to execute. For professional traders, especially those employing advanced multi-leg strategies, the spread is a critical factor in determining whether a trade is practical. Narrow spreads make complex strategies viable, while wide spreads can erode profitability before a position is even established.

strike price

In order for the options market to function, there must always be both buyers and writers. The writer, or seller, takes the short side of the contract, while the buyer takes the long side. This relationship exists regardless of whether market participants broadly agree on the likely direction of the underlying asset. Even if nearly everyone believed prices were bound to rise or fall, there would still be traders willing to assume the opposite side for reasons of protection. For example, someone who owns a stock may be optimistic about its prospects but still purchase a put option as insurance against an unexpected decline. This need for both speculative and protective positions ensures that long and short opportunities exist in multiple forms, which is crucial for maintaining active trading cycles and supporting the wide range of strategies that options make possible.

A central feature of every option contract is the strike price—the fixed price at which the underlying asset can be bought or sold if the option is exercised. This price remains in effect until the option expires, although adjustments are made automatically to account for corporate actions such as dividends or stock splits. For a call option with a $30 strike, exercise gives the buyer the right to purchase shares at $30 each, regardless of whether the stock is trading at $30.01 or $875. The writer of that option is obligated to deliver the shares at the strike price, even if that means purchasing them at a much higher market rate. In some cases, rather than transferring the actual shares, contracts are settled in cash based on the difference between the strike price and the market price.

Similarly, a put option with a $20 strike price allows the holder to sell the asset at $20, even if the market value has fallen to $19.99 or all the way to zero. The writer of the put, on the other hand, is bound to buy the asset at $20, regardless of how far the price has dropped. For the holder, the value of the put comes from receiving the difference between the exercise price and the lower market price, which locks in protection against loss.

When options expire in the money, the outcome differs depending on whether it is a call or a put, and on whether the party is the holder or the writer. A call option in the money requires the writer to deliver the underlying security or its cash equivalent, while the holder gains the right to receive it at the advantageous strike price. In contrast, a put option in the money requires the writer to take delivery or pay the cash equivalent, while the holder has the right to transfer the security or receive the cash settlement. The difference in who delivers and who receives under these circumstances is what allows options to support such a variety of trading approaches and strategies.

The exercise process itself is managed through the clearinghouse, which acts as an intermediary between buyers and writers. The option holder initiates the exercise by notifying the clearinghouse, which then assigns the obligation to a writer chosen at random. Neither the buyer nor the seller knows who they will be paired with, which ensures fairness and consistency in settlement while maintaining the anonymity of the market.

Every option has a finite life span, and that life ends on the expiration date. Once this date arrives, the contract is no longer valid. By that deadline, the option must either be exercised, settled, or it simply expires worthless. If the option finishes out-of-the-money, it has no value beyond expiration. When settlement does occur, it is facilitated by the clearinghouse, which manages the process automatically. From the trader’s perspective, this means that no direct action with the counterparty is required—the clearinghouse handles assignments and ensures obligations are met.

Options also differ in terms of when they can be exercised, and this is where the distinction between American-style and European-style contracts comes into play. Despite their names, these styles are not strictly tied to geography anymore, but to exercise rules. An American option grants its holder the flexibility to exercise at any time from purchase until the expiration date, offering more choice in timing. A European option, by contrast, can only be exercised on the expiration date itself, which makes its structure more rigid. Historically, American exchanges issued primarily American-style contracts and European exchanges issued European-style ones, but today both types are listed around the world. Understanding which style applies to your option is important, as the ability—or inability—to exercise early can influence both strategy and valuation.