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Module 3 · Lesson 3 of 6An option gives its buyer the right, but not the obligation, to buy or sell at a set price. That one-sided choice changes the shape of risk completely compared with futures.
Risk warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. Educational content only. Nothing here is a recommendation, and no result is guaranteed.
An option is a contract that gives the buyer the right, but not the duty, to buy or sell an underlying asset at a fixed price on or before a certain date. The buyer pays a fee for that right. The seller (also called the writer) collects the fee and takes on the obligation if the buyer chooses to use the right.
A useful analogy is a non-refundable deposit. Imagine paying £1,000 to reserve the right to buy a house at £300,000 within three months. If prices jump, you use the right and gain. If prices fall, you walk away and lose only the £1,000.
Here are the five terms to know.
Options are American style if they can be used any time up to expiry, and European style if only at expiry. The names say nothing about geography.
The option buyer's maximum loss is the premium paid. The option seller takes the opposite side: limited reward (the premium) but potentially much larger risk.
The payoff of a call at expiry, per ounce, is the larger of zero and (market price minus strike). Profit is the payoff minus the premium paid. The breakeven is where the profit is exactly zero: strike plus premium.
Gold is at $2,000. You buy a call option on 100 ounces with a strike of $2,000, expiring in one month, for a premium of $30 per ounce.
| Gold at expiry | Payoff per ounce | Profit per ounce (payoff - $30) | Total profit or loss (x 100) |
|---|---|---|---|
| $1,950 | $0 | -$30 | -$3,000 |
| $2,000 | $0 | -$30 | -$3,000 |
| $2,030 | $30 | $0 | $0 |
| $2,100 | $100 | $70 | $7,000 |
| $2,200 | $200 | $170 | $17,000 |
Notice the asymmetry. Below $2,000 the loss stops at $3,000 however far gold falls. Above the breakeven the profit has no fixed upper limit. But the price must rise by more than the premium before you make anything, and the option can expire worthless.
A put works in the opposite direction. The payoff at expiry per ounce is the larger of zero and (strike minus market price). The breakeven is strike minus premium.
You buy a put on 100 ounces with a strike of $2,000 for a premium of $25 per ounce.
Now suppose a holder of 100 ounces of physical gold bought at $2,000 worries about a fall. They buy a put with a strike of $1,950 for $25 per ounce.
The premium is the price of peace of mind, like an insurance premium. If nothing bad happens, it is gone.
Before expiry, an option's premium has two parts.
Gold is $2,030 and a call has a $2,000 strike with a premium of $50.
If nothing else changed, time value shrinks as expiry nears and reaches zero on the day. This steady loss is called time decay. It works against the buyer and in favour of the seller.
Three more factors push premiums up or down: a longer time to expiry raises the premium, higher expected price swings (volatility) raise it, and the gap between spot and strike matters.
That gap has its own vocabulary, called moneyness.
| Term | Call option | Put option |
|---|---|---|
| In the money (ITM) | Market price above strike | Market price below strike |
| At the money (ATM) | Market price about equal to strike | Market price about equal to strike |
| Out of the money (OTM) | Market price below strike | Market price above strike |
Every option buyer has a seller. A seller's profit at expiry is the premium minus whatever the buyer collects.
Take the $2,000 call from earlier, sold at a $30 premium on 100 ounces. The seller receives 100 x $30 = $3,000 upfront.
The seller's profit is capped at the premium but the loss on a short call has no fixed limit, since a price can keep rising.
Selling options without owning the underlying (called naked or uncovered selling) can produce very large losses and is not suitable for beginners. Many people are drawn in by the small regular premiums and underestimate the rare large loss. Leverage and options can lose money quickly.
Options explain a lot of what happens in markets: price swings around big events are partly the result of option positions being adjusted, and the expected volatility priced into options is itself a market signal. Some retail platforms offer options-like products, so always check whether your loss is limited to a premium or can run further. A bought option has a known maximum loss; a CFD does not work that way (see CFDs Explained).
Compare the shape of risk with the previous lesson, Forwards and Futures, where both sides are obliged to complete the deal.
The maximum loss on a bought option is known in advance (the premium), but the option can expire completely worthless, so a 100% loss of the premium is common. Neither product is safe, and both need care.
That depends on the product and the broker. An in-the-money option may be exercised or settled automatically, and an out-of-the-money option simply expires worthless. Check the contract terms.
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