the Greek philosopher Thales who invented options by, not BUYING, but saying he was INTERESTED in buying the land’s olive presses. When the bumper olive crop came in, he simply sold his option for more than he’d paid, and everyone was happy. And what would have happened if olives that year had failed? Well, he’s simply not have exercised his option. Seriously. It’s – that – simple!

Now, with vanilla options, we need to come to grips with two products: the underlying asset, which has a present value, a future value and a value we’re aiming at – what we call its STRIKE price. The second product is the option itself, which we can buy or sell. The option ALSO has a value. THAT value depends on the asset’s current price, but also our strike price and the amount of time remaining for the asset to HIT that strike price. That’s the moment the option expires, its expiry or expiration date. The closer we are to that deadline, the less time the option has to achieve or improve its strike price. This affects the price of the option, which we call its PREMIUM.

Let’s go back to the top. An option is a right to buy or sell an underlying product at a pre-specified time in the future and for a pre-specified price. It’s NOT an obligation. When the expiry date comes along we can either exercise the option or ignore it. If we ignore it, we’ll have lost the premium we paid for the option. Why that premium? Well, an asset can only be bought or sold once at that specific moment. An option is your sole right as the holder of the option to buy or sell the underlying asset. Nobody else can have it. You’ll either make a profit or you won’t. And that option is in itself worth money.

You bought that option from a counterparty. If you bought a call option, you now have the option to buy the asset at its pre-specified price when the option expires. If the market price for the asset is higher, you’ll be buying it at the lower strike price, which you agreed upon with your counterparty, and selling the asset for a profit. If you bought a put option, you have the right to SELL the asset at the strike price. Here, the market price has to be lower so that you can buy the asset from the market and sell it to your counterparty for the higher strike price. He has no choice – he accepted you premium – the cost of the option – and now he’s obligated to buy it from you – even though he can get it for cheaper in the marketplace.

If you bought a call option and the market price is LOWER than the strike price, you simply don’t exercise your option. Why buy an asset at a higher strike price and then sell it for a loss, if you have no obligation? Likewise, with a put option.

The problem begins if you SELL an option. Remember – there’s a difference between buying a put or a call option and SELLING a put or a call option. As the buyer of the option, you pay the premium. As an option SELLER, you GET the premium. Which is the beauty of vanilla option trading: you can actually get paid at the start of the transaction. The problem is that then you’re obliged to fulfil the desires of your counterparty: you CAN choose to not exercise an option you bought; you can’t simply ignore an option you sold. You’ve already been paid – now you have to supply – or buy – the product, no matter what its price.

Clearly, in both cases, if your counterparty is a broker, you won’t have to buy or sell the underlying asset in EITHER case – you’ll simply settle the price difference. But remember – as an option buyer you have the choice to exercise or not exercise your option, but you’re paying and perhaps losing a fixed premium. As an option SELLER you might be GETTING a premium ahead of time; but at the moment of expiration you WILL be at the mercy of the option buyer. And there’s no limit to the differential between the strike price and the market price you may have to pay.

OK. So we have an asset and we have an OPTION on the asset. The asset’s value is easy: it’s the value of the underlying asset as expressed by the market – as it appears on the chart. The PREMIUM is an entirely different matter. Pricing a premium is a science. It depends on two values: an intrinsic value and a time value. An option’s intrinsic value is how much it would be worth if it were exercised at any specific moment – the difference between the strike price and the market price. Let’s say I bought an option on oil when its market price was $40 set to expire in a week at a strike price of $50. It’s now 4 days later and oil has jumped to $60. I can buy oil from my counterparty at 50 and sell it at 60 and make a $10 profit. That’s the option’s INTRINSIC value.

My option is currently “in the money”. If the market price had been $45, I would have been out of the money, to the tune of $5. I simply wouldn’t have exercised my option and lost the premium I paid. Either way, since this is a European option, I can’t exercise my option as yet. At the moment, oil still has 3 days until my option expires. If it deteriorates, I may not exercise the option. However, it still has time to improve. When I bought the option, it had more than DOUBLE the time to improve; and the closer I am to expiration, the less time oil has to increase far beyond the strike price. This is the option’s time value: the more time, the more valuable the option.

There are lots of methods and formulas to calculate an option’s premium. Most of them take into account the market’s volatility. For now, simply remember that the premium equals the option’s intrinsic value plus its time value.

So remember, if you paid a premium of $5 for a call option on oil to buy at a strike price of $50 in a week’s time, if oil rose to $60, you’re $10 into the money and you should exercise the option. Along with the premium, you’ll still have made a $5 profit. If it rose or fell to anything under $55, you’ll not exercise the option and only lose your premium – $10.

If you buy a put option for the same $5 for oil to fall to $20 and it only falls to 30, you don’t exercise your option. Oil needs to drop beneath the strike price minus the premium – i.e. below $15 for you to be both in the money and profitable.

If you SELL the same option, you’ll be $5 richer at the start of the week, but no richer. If the option goes in your favor, your counterparty simply wont exercise it. He WILL, though, if he’s in profit – either higher than 50 if you sold him a call, lower than 20 if you sold him a put. And we’ve seen oil at $120, so there’s nearly no saying how much loss you’ll be forced into.