Options are the right to buy or sell an underlying asset at an agreed price at a given time in the future. The agreed price to buy or sell the asset is called the strike price, whereas the date by which the option needs to be used is called the expiry date. Options have been around since the times of the Samurai when they used options to protect themselves from the seasonal fluctuation of rice prices by locking their price for the future. Yet only recently has there been an increasing interest by retail investors who have flooded the market due to commission-free brokerage services. According to a report by Barclays, “The volume of traded options has increased by 3x on YoY basis”. This is significant as the growth in the options market along with portfolio customization options has made options one of the most important financial tools for all finance geeks.

Before diving into what options are used for, it is easier to understand certain financial jargon related to options. Options are divided into two types based on what kind of right is provided. The contract which gives the holder the right to buy is called a call option, whereas a contract with the right to sell is called a put option. The person buying the put or call is referred to as the option holder whereas the person who is willing to fulfill the call or put at the agreed price in the future is called the writer. Depending on limitations of execution and types of payoffs, options can be divided into many types.

American options, also known as “vanilla options” for being the most basic, are the most traded options in the market. For the sake of simplicity, I will only be focusing on American options.

A call option is the right to buy an asset at a strike price, whereas a put option is the right to sell. When you buy a call you are hoping for the price of the asset to increase, but when you buy a put you are hoping for the price to fall.

Let's say the current stock price of Falcon Corporation is $100. The corporation is set to release its quarterly earnings tomorrow. After reading the article on Falcon Finance Ryan buys a call option with a strike price of $110 hoping the price will increase. But on another hand, Victoria buys a put option with the same strike after being persuaded by one of her friends. The next day they wake up to find that after a great earnings report the price of the stock has doubled to $200.

Ryan thinks the profit is good enough for him so he exercises the option. Since the option allows him to buy Falcon Corporation stock at $110 even when the current price of the stock is $200, he pockets the difference between the price of the stock at exercise date and strike price. Victoria, on other hand, has the right to sell the stock at a price of $110. But since the market price is $200, she is better off not doing anything. And so, Victoria will not exercise the option.

Let's consider the case where the price actually drops to $50. Here Ryan’s call becomes worthless as he has the right to buy the stock at $110, but the market price is lower than that, so he would rather buy from the market. In this case, he is better off doing nothing. On the other hand, it’s time for Victoria to celebrate, since she holds the right to sell the stock to the writer of the put at a strike, which is $100. Since the current price of the stock is lower than $110, she buys the stock at the market price and sells it to the writer at $110.

Calls are profitable only if the current price is higher than the strike and become worthless if the strike is higher. Puts are profitable only if the current price is higher than the strike and become worthless if the strike is higher.

Options help in speculation as it limits your risk and allows leverage. Instead of risking a large movement on others when you buy a stock, you only lose the premium. Say, you buy a stock at $100 and an option with a strike price of $100 for $5. If the stock moves to $75, the stock would yield a loss of $25, but you only lose your initial premium of $5 with the option. Similarly, if you use options correctly, you can earn exponential profits. Say, you buy a stock at $100 and 20 options with a premium of $5 and the strike $100. Now if the price of the stock rises to $125, the stock yields a profit of $25, but the profits from the options would be $400 (20x[25-5]).

While options sound lucrative with potentially high upsides, we need to remember that an option comes with an expiry date. The moment your option expires, it loses all its value, and you cannot exercise your right. While a loss in stock might be recouped with a quick rebound, if you incur a loss through an option expiration, your investment loses all its value instantaneously.

Buying an option to diversify your portfolio or even speculating a small portion of your portfolio is a great way to increase your profits. However, it is important to understand that options are volatile. A small miscalculation and an entire portfolio of short-dated, out of money options can be lost. But if you strategize correctly, earning millions of dollars through an option is a possibility. For example, a YouTuber by the name “Roaring Kitty'' saw his $53,000 in call options bought in 2019 on GameStop (GME) rise to $48 million U.S. dollars by January 2021 – a whopping 90566% return in less than a year.