How Equity Options Work

Options are the most useful and most misused instrument available to a one-person options operator. By operator I mean someone running options trading as a real practice: research, structure, risk, review. Traders place orders. Operators run the stack.

Used carelessly, options will destroy a portfolio. Used with discipline, they let one person run a strategy that would otherwise require an institutional desk.

This is the first piece in a methodology series. It covers the mechanics: what an option is, how it gets priced, what the Greeks measure, and why selling options is a different game from buying them. Foundation, not opinion.

The instrument

Standardized exchange listed options are younger than most people assume. They were introduced on the Chicago Board Options Exchange (CBOE) in 1973. Before that, options were over the counter, illiquid, and required custom negotiation on every spec. The original use case was hedging, which is why most textbook strategies skew defensive.

Today the use case is broader. Options are an instrument for directional trading, structured exposure, volatility plays, and hedging. Retail accounts for roughly 40% of total US equity options volume, which is one reason the liquidity has filled out across hundreds of underlyings.

One data point worth holding: in 2023, average daily notional volume in US single name equity and ETF options was about $650bn, compared to roughly $500bn in the underlying shares themselves (source: Nasdaq). The derivative is now larger than the cash market it references.

This article uses single name equities as the underlying, though most of the framework applies to ETFs and indices. It also focuses on American style options, meaning options that can be exercised any time before expiration. Index options are typically European style and settle differently, but that is a different article.

Calls and puts: the mechanics

Two types of options exist: calls and puts. The buyer and seller have very different roles in each.

A call option gives the buyer the right to buy 100 shares of the underlying at a fixed strike price within a fixed time window. The seller has the obligation to deliver those shares if assigned.

A put option gives the buyer the right to sell 100 shares of the underlying at a fixed strike price within a fixed time window. The seller has the obligation to buy those shares if assigned.

Both rights and obligations only activate if the contract is "in the money" at expiration. If it is out of the money, the contract expires worthless and the premium paid by the buyer becomes the seller's gain.

A concrete example

Take a call contract: HIMS 19 Jul 24 21 Call. That is an option on 100 shares of Hims & Hers Health (HIMS) with a $21 strike, expiring 19 July 2024.

Assume on 31 May 2024 the buyer paid $200 ($2 per share) for this call, with the stock trading at $20. Here is how it plays out at expiration:

Stock closes at $23 on 19 July 2024. The buyer receives 100 shares at $21 each. The unrealized gain on the shares is ($23 minus $21) times 100, or $200. After deducting the $200 premium paid, the net result is zero. So $23 is the breakeven. Above that, profit. Below, loss.

For the seller, the mirror image. They buy 100 shares at the $23 market price and deliver at $21, losing $200 on the position itself but offsetting that with the $200 premium received. They also break even at $23.

These cash flows settle automatically at expiration.

What happens before expiration

The interesting scenarios are price moves before expiry. Three illustrative cases for the same call:

1. Mid June, stock at $21. The call would be worth roughly $170 ($1.70 per share). The underlying just touched the strike but the option is not yet ITM, and the time value compressed slightly. Result: $1.70 / $2.00 minus 1, or −15%.

2. Mid June, stock at $23. The call would be worth roughly $300 ($3.00 per share). $2.00 of intrinsic value, $1.00 of remaining time value. Result: +50%.

3. Mid June, stock at $19. The call would be worth roughly $100 ($1.00 per share), all time value. Result: −50%.

These are the small price movements that make option positions feel volatile. They are also the moments where most operators make impulse decisions.

ITM, ATM, OTM

The strike is the reference price that defines the option's status.

• OTM (Out of the Money): call strike above current price; put strike below current price.
• ATM (At the Money): strike equals current price. Uncommon at any precise moment.
• ITM (In the Money): call strike below current price; put strike above current price.

For OTM options, all the value is time and volatility. There is no intrinsic component. This matters a lot for what comes next.

How options are priced

Pricing comes down to one thing: the probability that the option expires in the money. Market makers compute this probability continuously and quote it as a bid and ask. Modern dynamic pricing engines do most of this work.

Several dozen market makers compete on liquid US options. The competition tightens spreads and forces quoted prices to align with fair value given known information. Macro factors like Fed rate decisions and name specific factors like guidance, M&A activity, and earnings catalysts all show up in pricing through changes in implied volatility (IV), which is the volatility expectation embedded in the option price.

The reference point for IV is realized volatility, the actual historical volatility of the underlying. The two are related but not equal. IV is forward looking and reflects what the market expects.

For illiquid names with few market makers, bid ask spreads can be very wide. This is a soft constraint on the universe a one person operator can trade.

Several free calculators let you back out IV and theoretical pricing yourself: Barchart, CBOE, Interactive Brokers.

The pricing models

Three models dominate practical and academic pricing. Worth knowing what each one is for, even if your broker handles the math.

Black, Scholes and Merton (1973). An analytical formula. Designed for European options (exercise only at expiration). Assumes geometric Brownian motion of the underlying, no dividends during the option's life, no transaction costs, and constant volatility and risk free rates. Computationally light. Still the workhorse for indices and a useful first approximation everywhere else.

Binomial model. A numerical method that builds a tree of possible underlying prices and works backwards to value the option. Designed for American style options (exercise allowed before expiration). Can incorporate dividends and rate changes. More flexible than BSM but heavier on compute.

Monte Carlo simulation. Generates many random price paths under specified parameters and prices the option as the expected payoff. Most flexible of the three. Returns a distribution of outcomes rather than a point estimate. Used for path dependent or exotic structures. Heavy on compute and overkill for most single leg trades.

For an operator working with single name vanilla American options, the binomial framework is what your data provider is using under the hood. You do not need to implement it. You do need to understand what its outputs mean.

The drivers of option value

For long positions, value moves with these drivers:

A buyer of a call wants the underlying up. A buyer of a put wants the underlying down. Both buyers want volatility to expand. Both lose to the passage of time.

For sellers, every direction flips. A seller of an unsecured call or put has bounded upside (the premium received) and very large downside. These are called naked positions and carry meaningfully different risk.

Naked positions sometimes make sense. Example: you would be happy to own 100 shares of Delta Air Lines (DAL) at $49. You sell a DAL 21 Jun 24 49 Put and collect $131 ($1.31 per share). If DAL closes above $49 at expiry, you keep the premium. If it closes at $47, you get assigned 100 shares at $49, plus the $131 premium offsets some of the markdown, leaving an unrealized loss of $69 on a position you wanted to own anyway. Acceptable for a long term investor with a clear thesis on the underlying.

Selling without that thesis is just leverage on a coin flip.

The Greeks

The Greeks measure how option value changes with respect to each driver. The three that matter most for an operator:

Delta

Sensitivity to underlying price. A call with delta 0.25 (OTM) gains roughly $0.25 per share for every $1 move up in the underlying. A call with delta 0.90 (deep ITM) gains roughly $0.90.

Delta also approximates the probability the option expires ITM, but it is a rough proxy, not a forecast. A 0.20 delta call has roughly a 20% chance of finishing in the money. In practice, you need a thesis on the underlying's repricing driver, not a probability estimate.

The rate of change of delta is called gamma. Gamma is highest at the money. Small moves in the underlying produce outsized delta changes for ATM options, which means ATM positions are very sensitive to whippy price action.

Vega

Sensitivity to implied volatility. A call with vega 0.30 gains $0.30 per share if IV increases by one percentage point. Vega is the reason earnings plays are tricky: IV typically crushes after the print, even on a directional win.

Theta

Sensitivity to passage of time. Always negative for long positions. A call with theta −0.07 loses roughly $0.07 per share per day if nothing else changes. Theta accelerates as expiration approaches, especially for OTM contracts.

A call with theta −0.07 trading at $3.00 with one day left will be worth $2.93 tomorrow, holding everything else constant. With 10 days left, the same theta implies $0.70 of decay over those 10 days, which is roughly a fifth of the position's value.

There are more Greeks (rho, vanna, charm), but for the operator, delta, vega and theta are the operational toolkit.

When options actually make sense

Four cases where an option is the right instrument:

1. You have a directional view with a defined target and a time window.
2. You want leverage without margin: the gap between premium paid and notional exposure.
3. You want bounded risk and defined return: maximum loss known in advance.
4. You want to hedge a stock position.

In all four cases, options compress decisions into a smaller window. That is a feature and a risk.

The discipline

Reading the theory is necessary but not sufficient. In my experience, you need around 100 trades and the associated mistakes before options become as routine as equities. There is no shortcut for the screen time.

Four non-negotiables for every option trade:

1. Analyze the underlying. Identify the catalyst that will drive repricing.
2. Define the entry and the target.
3. Compute the optimal structure across strikes and expirations for the chosen risk reward.
4. Track the position continuously. Greeks shift fast, and assumptions decay.

Done with discipline, options become a useful instrument. Done without it, the structure that compresses returns compresses losses the same way.

The next piece in this series will work through specific structures (verticals, calendars, diagonals) and the trade offs each one carries.

For the methodology behind the live track record, see the Track Record for monthly performance and the Method for the full eight-step framework.