What are financial options and how to trade calls and puts

Options are financial instruments that are part of the large family of derivatives. Simply put, their value does not exist on its own, but depends on that of another asset: it could be a stock, an index, a currency, or even a raw material. They are considered complex, it’s true, but also incredibly versatile. Those who know how to use them well can protect themselves from market fluctuations or try to profit from them.

A concrete example makes it easier to understand. A pasta factory that fears an increase in the price of wheat can buy a call option. This instrument grants it the right, but not the obligation, to buy wheat at a price set today. If the price rises, the pasta factory will continue to pay the agreed-upon price, thus protecting itself from market surges. Options, however, aren’t just for protection. There are also those who use them for trading or to generate extra income, for example by selling "covered" options on stocks they already own, profiting from market movements without excessive exposure.

In this guide, we will truly understand how options work and what lies behind terms like strike price, expiration, and premium. We will also discover why they can become a strategic tool for those who want to hedge against risk, but also for those aiming to seize new profit opportunities.

What is a financial option (definition and meaning)

A financial option is a contract that gives the buyer the right to buy or sell a specific asset, called the underlying, at a price set in advance by a certain date. It is not an obligation, but an option. This is the distinctive feature that makes them such flexible instruments. The underlying can be almost anything: a stock, an index, a currency, a commodity. The value of the option, in fact, depends entirely on the performance of its underlying. If the price of the primary asset changes, the value of the option also changes.

Difference between options and other derivatives (futures and CFDs)

Unlike other derivatives, such as futures or CFDs, options do not impose a reciprocal commitment. With a future or a CFD, the buyer is obligated to complete the transaction at expiration, whether they want to or not. With an option, however, the buyer can decide whether to exercise their right or let the contract expire. This detail makes all the difference: an option limits the risk to the premium paid, while with a future the potential loss is theoretically unlimited.

Practical example of a call and put option

An investor who buys a call option on ENI shares, with a strike price of 15 euros and expiring in three months, faces two scenarios at expiration:

• if the stock has risen to 17 euros, the investor can exercise the right to buy at 15 euros, immediately reselling it at a profit;
• if the price has remained below 15 euros, the investor will not exercise the option and will have lost only the premium paid.

In the case of a put, the mechanism is the opposite: the investor bets on a drop in price. If the shares fall below the established strike, he can sell them at a higher price than the market, collecting the difference.

How options work

Understanding how options work means understanding three key elements: who buys, who sells, and what the contract represents.

The Role of Buyer and Seller
Whoever buys an option pays a premium that gives them the right to choose whether or not to exercise the option.
Whoever sells it, on the other hand, collects that premium immediately but assumes the obligation to respect the buyer’s decision.
In short, the buyer buys an opportunity, the seller undertakes to respect it.

Strike Price and Expiration
Every option has two coordinates: a strike price and an expiration. The first indicates the price at which the underlying asset can be bought or sold. The second marks the time limit within which to do so. At expiration, the value of the option depends on how much the market price of the underlying asset differs from the strike price.

Payoff and Structure of an Option
The payoff shows how much you can gain or lose with an option at expiration. In the case of a call, the profit increases as the price of the underlying asset increases: the higher it rises, the more valuable the option becomes. With a put, the opposite happens: the profit increases if the price falls below the strike price.

To understand the position of an option, three simple but fundamental expressions are used. An option is at the money when the strike price coincides with that of the underlying asset: at that moment, it generates neither profit nor loss. It is in the money when exercising it is advantageous (for example, a call with a strike lower than the market price or a put with a higher strike). It is out of the money when it is not worth exercising because the strike price is worse than the current one.

Most important types of options

Let’s look at the main types of options below.

Call and put options: what they mean

• Call options give the right to buy the underlying asset at a predetermined price. They are chosen by those who expect prices to rise.
• Put options, on the other hand, give the right to sell. Those who buy them are betting on a market decline. These two instruments represent the foundation on which all options trading strategies are built.

European and American options
There are then two operational variants: European options, which can only be exercised at expiration, and American options, which can be exercised at any time up to the cut-off date. The latter offer greater flexibility, but also a slightly higher cost.

Vanilla and exotic options
Vanilla options are the traditional ones, with standard rules. Exotic options, on the other hand, introduce additional variables—such as barriers, conditions, or complex calculations—designed for more sophisticated strategies. These are tools reserved for expert traders seeking specific risk and return profiles.

How to calculate the value of an option

Behind the price of an option lies not only the value of the underlying, but a combination of dynamic factors.

Factors that influence the price
These include the current price of the underlying asset, the time to expiration, market volatility, interest rates, and, in some cases, expected dividends. Volatility is the most influential variable: the more unstable the market, the more the value of the options increases, because the probability that the price will move in the investor’s favor increases.

Black-Scholes Model Explained Simply
To estimate the theoretical price of an option, the Black-Scholes model is often used, a mathematical formula that takes all these elements into account. In simple terms, it calculates how much a future right is worth today, considering risk, time, and volatility. It is still a reference model today, even if real markets, with their sudden swings, can make it less precise.

The “Greeks” and Risk Management

To evaluate how an option reacts to market movements, traders use the so-called Greeks: Delta, Gamma, Theta, Vega, and Rho.

Each measures the option’s sensitivity to a specific variable (from the price of the underlying asset to time to interest rates). Let’s see what each one is and how they work:

• Delta: Delta is the first parameter of the options Greeks. It measures the change in the option price relative to changes in the price of the underlying asset. In other words, delta tells us how much the option price will change for each unit of change in the price of the underlying asset. For example, if the delta of a call option is 0.50, it means that the option price will increase by 0.50 for every 1 euro increase in the price of the underlying asset;
• Gamma: Gamma is the second parameter of the options Greeks. It measures the change in the option’s delta relative to changes in the price of the underlying asset. In other words, gamma tells us how much the option’s delta will change for each unit of change in the price of the underlying asset. For example, if the gamma of a call option is 0.10, it means that the option’s delta will increase by 0.10 for every 1 euro increase in the price of the underlying asset;
• Theta: Theta is the third parameter in the Greeks of options. It measures the change in the option price over time. In other words, theta tells us how much the option’s price will change for each passing day. For example, if the theta of a call option is -0.02, it means that the option’s price will decrease by 0.02 euros for each passing day;
• Vega: Vega is the fourth parameter in the Greeks of options. It measures the change in the option’s price over time. In other words, vega tells us how much the option’s price will change for each percentage point change in market volatility. For example, if the vega of a call option is 0.10, it means that the option price will increase by €0.10 for every 1 percentage point increase in market volatility;
• Rho: Rho is the fifth parameter in the Greeks of options. It measures the change in the option price relative to changes in interest rates. In other words, Rho tells us how much the option price will change relative to changes in market interest rates. Specifically, Rho measures the change in the option price for every 1% change in interest rates.

Rho is important because interest rates are a critical factor influencing option prices. When interest rates rise, the value of call options tends to decrease, while the value of put options tends to increase. This occurs because the present value of a call option decreases when interest rates rise, as the cost of holding the position increases. Conversely, the present value of a put option increases when interest rates rise, as the cost of holding the position decreases. The Rho value of an option depends on the time to expiration of the option, the strike price, the current price of the underlying asset, and the level of market interest rates. Generally, call options tend to have a positive Rho, while put options tend to have a negative Rho.

The Greeks are essential for managing risk and understanding how exposed an options portfolio is to market changes.

Advantages and Risks of Options Trading

Investors like options because they can be used for speculation, to hedge a portfolio, or to build customized strategies. Those who buy them know the maximum possible loss (the premium paid) from the outset but can benefit from a potentially large gain.

The Risks of Selling Options and How to Manage Them
Option Selling, on the other hand, is a more slippery slope. The seller collects the premium immediately, but is exposed to potentially unlimited losses if the market moves against him. For example, those who sell an uncovered call risk having to buy the underlying at a price much higher than the market price. To limit the damage, experienced traders use hedging strategies (such as selling covered options or spreads) and set exit thresholds in advance to avoid being trapped in losing positions. In options trading, risk management isn’t a technical detail but a survival rule. Ignoring it can turn a modest profit into a significant loss, often within hours.

How Much Can You Make or Lose with Options
The potential gain for those buying an option is theoretically unlimited in the case of calls, and limited but significant in the case of puts. The loss, however, is always limited to the premium paid. For those selling, the opposite is true: limited gain, potentially high risk.

How to Trade Options on the Stock Market

Trading options means learning to use a powerful tool, but one that must be handled with awareness. Before beginning, it’s essential to understand where they are traded, how the purchase and sale contracts work, and what costs or guarantees trading platforms require.

How to buy options on trading platforms
Options are traded on regulated platforms, through specialized brokers. Simply open an account enabled for derivatives trading and select the desired option based on the underlying asset, strike price, and expiration date. It’s always advisable to start with small trades and with vanilla calls or puts, which are easier to manage.

Risks and benefits of selling options
Selling options can generate steady income, but requires preparation. The advantage is clear: you collect an immediate premium. But if the market moves in the opposite direction, the risk increases rapidly. For this reason, professional traders almost always sell covered options, that is, on assets they already own, to limit their exposure and maintain a margin of control.

Costs and margin requirements
Every options trade requires a margin, a sum that the platform blocks to cover potential risks. The amount varies based on the type of contract and market volatility. For those who trade regularly, it’s essential to understand your broker’s rules and constantly monitor your available margin: a technical detail that often makes the difference between a well-managed strategy and a costly mistake.

Options Trading Strategies

Once you understand how to buy and sell options, comes the most interesting part: learning how to use them strategically. Options allow you to build real investment architectures, adaptable to every phase of the market, whether it rises, falls, or stagnates. Each strategy has a precise logic, an objective, and a different level of risk.

Buying Call or Put Options
Buying a call option means betting on an increase in the underlying asset: if the price rises above the strike, the investor makes a profit. Buying a put option, on the other hand, is a defensive move: it serves to profit from a decline or to protect oneself from a decline in prices. In both cases, the maximum loss is limited to the premium paid, an advantage that makes buying options one of the easiest ways to get started.

Selling Call or Put Options
Selling options is a more advanced strategy, used by those with more experience. The seller immediately collects a premium, but exposes himself to the risk that the market will move in the opposite direction. If, for example, he sells a call and the price of the stock rises above the strike, he will still have to deliver the underlying at a lower price. This is why many traders choose to sell covered options, a more conservative form that reduces risk while maintaining a constant return over time.

Combination of Options (Spread, Straddle, Strangle)
More experienced traders combine multiple options to achieve customized risk-return profiles. Spread Strategies balance a call or put with another with a different strike or expiration, limiting losses but also profits. With the straddle and the strangle, however, the goal is to profit from volatility: you bet that the price will move decisively, without having to predict the direction. It’s a typical tactic in times of uncertainty, when the market is ready to snap in one direction or another.

Hedging with options
Options aren’t just for speculation, but also for defense. Hedging is the most used strategy by companies and long-term investors. Those who own a stock can buy a put option to protect themselves from potential downside. If the price drops, the gain on the option offsets the loss on the stock. It’s a kind of financial insurance, capable of saving a portfolio in times of turbulence, in exchange for the payment of a small premium.

Original article published on Money.it Italy. Original title: Cosa sono le opzioni finanziarie e come fare trading con call e put