Equity options are contracts on a specific company’s shares. They give the buyer the right, but not the obligation, to buy or sell those shares at a set price by a set date. The buyer pays an upfront premium for that right.
They sit alongside the underlying stock on major exchanges and are standardised by strike price, expiry month and contract size, though fine details differ by market. Traders use them to hedge, to take directional views, or to tailor risk and income in a portfolio without moving the cash equity position.
What do equity options specify?
Every contract locks in four essentials: the underlying share, a strike price, an expiry date and a contract size. The contract size is how many shares one option controls. In some markets it is 100 shares, in others it can be different. Exchanges can adjust sizes and strikes for events like stock splits or special dividends.
Equity options come in two main styles. American-style options can be exercised at any time up to expiry. European-style options can be exercised only on the expiry date. Many single-stock options are American-style, but this is not universal.
Most equity options are exchange traded and cleared, so the exchange’s clearing house stands between buyers and sellers, reducing counterparty risk. Some brokers also offer smaller or custom contracts. The exact features, tick sizes and expiries can vary by provider and venue.
Calls versus puts, and how the pay-off works
A call option gives you the right to buy shares at the strike. You want the share price to move above the strike before or at expiry, ideally by more than the premium you paid. A put option gives you the right to sell shares at the strike. You want the share price to fall below the strike by more than the premium.
Simple example: you buy a three-month call on XYZ with a strike of £50, paying a premium of £2 per share. If, near expiry, XYZ trades at £56, the call is £6 in the money. After subtracting the £2 premium, your gain is £4 per share before costs. If XYZ finishes at £49, the option expires worthless and your loss is the premium.
For a put, flip the logic. Buy a £50 put for £2. If the share finishes at £44, the put is £6 in the money and your net gain is £4 per share before costs. If the share finishes above £50, the put expires worthless and you lose the premium.
What drives an equity option’s price?
An option’s market price is usually more than just its intrinsic value. Two parts make it up:
- Intrinsic value: how much the option would be worth if exercised now. For a call, that is max(share price minus strike, zero). For a put, max(strike minus share price, zero).
- Time value: the extra you pay for the chance that the share price moves your way before expiry. Time value shrinks as expiry approaches.
Time value reflects expected volatility, time to expiry, interest rates and expected cash flows on the shares. Higher expected volatility raises the chance of a bigger move, so it tends to make both calls and puts more expensive. Longer-dated options carry more time value than short-dated ones, all else equal.
Dividends matter too. All else equal, expected dividends before expiry tend to lower call values and lift put values, because the share price usually drops on the ex-dividend date by roughly the cash amount paid. This is one reason single-stock options can behave differently from index options, where dividends are handled at index level.
Many traders talk about the Greeks. Delta is sensitivity to a £1 move in the share price. Gamma shows how delta itself changes as the price moves. Theta is time decay, the daily drip of time value. Vega is sensitivity to changes in implied volatility. You do not need to master these to grasp the basics, but they explain why option prices can move even when the share price does not.
Exercise, assignment and settlement
If you hold an in-the-money equity option at expiry, one of two things usually happens. Either it is exercised into a position in the underlying shares, or it is cash settled based on an official settlement price. Many brokers use automatic exercise thresholds for small amounts in the money, but the cut-offs and procedures vary by provider and market. Check the contract specs and your broker’s rules.
Early exercise is possible for American-style options. Holders of deep-in-the-money calls sometimes exercise just before an ex-dividend date to capture the cash payout, if the benefits outweigh the remaining time value. Put holders may exercise early if interest rates and funding costs justify it. Early exercise is never mandatory; it is a choice the option holder makes.
Writers of options take on the obligation side. If you sell a call without owning the shares, you can be assigned and required to deliver stock at the strike. If you sell a put, you can be assigned and required to buy stock at the strike. Assignment can happen any time for American-style contracts, including the day before an ex-dividend date. Keep that risk in mind if you are short options.
Where you meet equity options in practice
Investors and traders use equity options for several reasons:
- Hedging: a protective put can limit downside on a shareholding during a results season or a regulatory decision window.
- Income: a covered call sells upside beyond a chosen strike in return for premium. It can lift portfolio income in quieter markets, at the cost of capping gains.
- Directional views: buying calls or puts gives leveraged exposure to a move without tying up the full cost of the shares.
- Event trades: options can express views around M&A decisions, product launches or court rulings, where outcomes may be binary and timing is known.
- Relative value: some strategies pair options with stock, or options with other options, to isolate volatility, skew or time decay.
Because contracts are standardised by strike and expiry, liquidity typically clusters in a few popular strikes near the current share price and in the nearest months. Spreads can widen away from those points, especially in smaller stocks, so execution quality matters.
Risks, costs and quirks to remember
Options are wasting assets. If the expected move does not happen in time, time decay can eat the premium quickly. Short options carry obligation risk and, for calls, theoretically unlimited loss if the share rallies hard. Margin is usually required for short positions, and margin rules vary by regulator and broker.
Other practical points:
- Liquidity and spreads: thin markets mean larger bid–ask spreads and more slippage. Consider using limit orders and be realistic on size.
- Corporate actions: splits, rights issues and special dividends can lead to contract adjustments. The exchange or clearing house publishes the new terms.
- Operational policies: automatic exercise, minimum value thresholds and cut-off times differ by provider. Read the small print before expiry week.
- Settlement: many equity options are physically settled into shares. Others use cash settlement based on a specified closing or auction price.
- Tax and regulation: treatment depends on your country and can change. Professional, retail and institutional accounts may face different rules.
Compared with broad index options, equity options are more sensitive to company-specific events like earnings, guidance changes and management news. That can make implied volatility jump in the lead-up to results, then deflate once the uncertainty passes. Position sizing, timing and awareness of the company calendar all matter.