Now it's time to dig into what an options contract is. Let's start with a basic definition.

An options contract is a derivative investment that gives the owner of the contract the right to buy or sell a specified number of shares of a stock, ETF, or another predetermined underlying instrument at a certain price before a certain date.

There's a lot in that definition. To make things clearer, let's walk through an example. Let's say it's June and XYZ stock is currently trading at $49 per share.

Trader A thinks XYZ will go up in value in the next month, and Trader B thinks it'll go down.

Trader A could simply buy the stock, but they're not interested in building a position in shares. Instead, they decide to use options to speculate on bullish price movement without owning the stock.

Options are derivatives, which means their value is derived from the value of something else. In particular, the options price is derived from an underlying asset. In this case, the stock is the underlying.

Options are also leveraged instruments, which means investors can potentially earn higher returns or experience greater losses using relatively small amounts of capital. Therefore, options can be an alternative way for Trader A to speculate on the price movement of a security. Now, back to the example.

So, Trader A buys an options contract from Trader B that gives Trader A the right to buy XYZ at a certain price, known as the strike price, and before a certain date, known as the expiration. The strike price and the expiration are specified in the contract. This particular contract has a strike price of $50 and expires in July (one month).

In exchange for that right, Trader A pays Trader B a premium (options lingo for "price"), which for this XYZ option is $2. A standard options contract consists of 100 shares of the underlying stock. The total amount an investor pays for a single options contract equals the price of the option ($2) times the options multiplier (100), or $200 plus transaction costs (contract fees). So, Trader A pays Trader B $200 to buy one options contract. It's important to understand that Trader A hasn't actually bought any shares of XYZ yet—they only bought the right to buy.

Trader B collects the $200 in exchange for promising to sell XYZ at $50 any time between now and the July expiration date. Basically, they're obligated to sell if Trader A exercises their right to buy before expiration.

Notice the difference: The buyer has the right to buy, and the seller has the obligation to sell. Trader A doesn't have to exercise their right. If they don't, Trader B won't be obligated to sell. But if Trader A does exercise their right, Trader B must fulfill their end of the deal. Note, again, that this is a simplified explanation—usually, a market maker mediates the buyer and seller relationship, but we'll get into this a little later.

Now this may seem a little strange—why would the right to buy have value? Or, why would the seller be compensated for taking on this obligation? Well, to help clear this up, let's look at some possible outcomes of our example.

Let's assume that before the options contract expires, the price of XYZ jumps from $49 to $53. Trader A could exercise their right and buy 100 shares from Trader B at the strike price—a much more desirable price of $50. Therefore, this right allows Trader A the ability to purchase a stock for less than its current market price. In this circumstance, it's easy to see why Trader A would be willing to pay $200 for the XYZ option. We can all appreciate the value of paying less for something that's more expensive.

On the other hand, let's suppose that XYZ falls from $49 to $48 before the options contract expires. Trader A could still exercise their right to buy at $50, but why would they want to pay more for something they could buy on the market for cheaper? In this situation, the XYZ option would likely go unexercised and expire worthless, leaving Trader A out their $200.

Now, let's look at it from the seller's perspective. In both cases, Trader B keeps the $200 premium they received for selling the option, no matter what. However, if the stock price is higher than the strike price at expiration, the seller will likely have to sell the stock (called assignment) for less than it's worth. If the seller didn't already own the stock, they would need to buy the stock to fulfill assignment and deliver 100 shares per contract. They would then lose the difference between the strike and the market price, which would cut into their $200 profit. This would be a less-than-ideal outcome for Trader B. Therefore, the seller hopes that the contract expires worthless because they will get to keep the full premium.

This example shows what would've happened if Trader A wanted to exercise their right to buy—a process known as exercising the option—and waited until expiration to do so. But that's only one possible outcome of an options trade.

Many traders buy and sell options contracts long before expiration without ever intending to exercise their right to the underlying. Keep in mind, however, there is no guarantee of being able to close an options position because there are circumstances in which trading in the options and/or their underlying stocks are halted, or when the quote on an options contract can actually be zero.

Options contracts fluctuate in value and can often be bought or sold before expiration for a profit or loss. Remember the premium we introduced earlier? Like a stock price, that premium is constantly changing in value, and as it changes, your options contract becomes more or less valuable. Because our example focused on the value of the options premium at expiration, options pricing may seem simple. However, pricing is more complex when you consider how the options premium would gain or lose days, weeks, or months from expiration.

An important thing to understand is that options pricing is different from stock pricing. A stock's value only comes down to its price and any dividends. The options premium, however, is influenced by multiple factors—the value of the underlying stock, of course, but also things like how much time is left until expiration and the perceived risk of the underlying, also known as implied volatility.

Let's go back to our example to illustrate. Suppose that a week into the trade, the price of the underlying stock spiked from $49 to $52. With each dollar that price goes up, the value of the option increases. Let's assume by the time the underlying stock reached $52, the option increased from $200 to $250 per contract. Trader A now holds an options contract that's worth a lot more than it was when they bought it. They could sell this contract and profit from the price appreciation.

Conversely, if the premium fell from $200 to $150 per contract, Trader B, who sold the option, could buy the contract back at this lower price, capturing the $50 difference. In other words, an option seller can usually close the position for a profit by buying the contract at the lower price. Selling-to-close or buying-to-close are types of trades that close options positions and are also known as "closing transactions."

It's important to keep in mind that a little price move in the underlying can result in a big percentage move in the options premium. And a big move in the underlying can result in an even bigger percentage move in the options premium. This is leverage at work. Using a relatively small amount of capital to control a much larger amount of the underlying security magnifies both gains and losses. Leverage can be a benefit if the trade goes your way, but a burden if it doesn't. Leverage is the chief reason why options are considered risky.

Whenever entering a trade, it's important to consider the potential risks, returns, and your probability of success. You should always know what you stand to lose and be willing to accept it.

If your head's starting to spin, stick with us—we'll revisit all these ideas later. But at this point, you've been introduced to many of the core concepts. Over the next two lessons, we'll expand on these, reinforce key points, and fill in all the important details.

Now, let's return to the two options paper trades from the previous video. If you're curious about how they performed, watch the video below to revisit these trades to see what happened and why.