Understanding an options contract

A broker's option chain shows the terms and pricing of each contract. Here is what the main fields mean, using an illustrative example rather than a live quote: a call on a stock trading at $613, strike $650, expiring in 23 days, premium $12.50. A call gives the buyer the right to buy 100 shares at the strike price, here $650, until the expiry date. A put is the right to sell.

The fields

Premium, $12.50. The price per share. This example contract controls 100 shares, so it costs $1,250. While held as an option, the buyer's maximum loss is that premium plus fees. Exercising a call creates a stock position with its own cost and risk.

Breakeven, $662.50. Strike plus premium for a call, strike minus premium for a put. The stock must be above $662.50 at expiry for the buyer to profit. That is $49.50, or 8.1%, above today's price.

Delta, 0.35. With other inputs unchanged, the option's price changes by about $0.35 for a small $1 move in the stock, or $35 per contract. Delta changes too. Traders sometimes use 0.35 as a rough model-based proxy for a 35% chance of finishing above the strike. It is not a measured probability or a 35% chance of making a profit.

Implied volatility, 60%. The size of move the market is pricing in, stated as a yearly figure. Over 23 days, 60% gives a simplified one standard deviation estimate of about $92 either way ($613 times 60% times the square root of 23/365). A bell-curve model puts about two thirds of outcomes inside that range. This is a model estimate, not the stock's measured odds; actual moves can differ sharply.

Theta, -0.60. Time decay. With nothing else changing, the option loses about $0.60 per share, $60 per contract, every day. Decay usually speeds up in the last few weeks, most of all for options with a strike near the stock price.

Open interest and volume. Open interest is how many contracts exist. Volume is how many traded today. High open interest and a tight bid-ask spread, the gap between the best price to buy and the best price to sell, can help with trading, but do not guarantee an order will fill or the price you will receive. A large spread relative to the option's price can make trading costly.

The payoff chart

The illustration above shows profit or loss at expiry for one example call contract, before fees. It stays flat at the full premium lost until the stock reaches the $650 strike, then rises. It crosses zero at the $662.50 breakeven and becomes profitable above it. The blue line is today's price and the red line is breakeven. The gap between them is the move needed to break even at expiry.

The prices in this lesson are examples, not current quotes. Check the live bid and ask at your broker before you place an order, and use a limit order so you set the price you pay.

Before trading options, read Characteristics and Risks of Standardized Options from the Options Clearing Corporation. Buyers of options can lose 100% of the premium paid.

Try this

In a paper trading account, open the option chain for a stock you follow and pick one call about a month out. Write down its premium, breakeven, delta, implied volatility and theta, and the cost of one contract. Check the same contract each day for a week and note how much value theta took while the stock moved.