Options Basics: Calls and Puts
Advanced
An option is a contract that gives the buyer the right — but not the obligation — to buy or sell a stock at a set price (the 'strike price') before a set date (the 'expiration date'). A 'call' option gives the right to BUY the stock at the strike price — buyers use calls when they expect the price to rise. A 'put' option gives the right to SELL the stock at the strike price — buyers use puts when they expect the price to fall, or to protect existing shares from a decline. The price paid for an option contract is called the 'premium'.
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Call option: right to buy at the strike price. Profits if the stock rises above strike + premium paid.
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Put option: right to sell at the strike price. Profits if the stock falls below strike − premium paid.
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Premium: the price paid to buy the option contract — this is the maximum a buyer can lose.
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Strike price: the fixed price at which the contract can be exercised.
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Expiration date: the date after which the contract is worthless if unexercised.
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One standard equity options contract typically represents 100 shares of the underlying stock.
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→Intrinsic Value vs. Time Value (Options Pricing)
Advanced
An option's premium is made up of two parts. 'Intrinsic value' is the amount the option would be worth if exercised right now (how far 'in the money' it is). 'Time value' (or extrinsic value) is the extra amount buyers pay for the possibility that the option becomes more valuable before expiration. Time value shrinks as expiration approaches — a process called 'time decay'.
Formula
Call Intrinsic Value = max(0, Stock Price − Strike Price)
Put Intrinsic Value = max(0, Strike Price − Stock Price)
Time Value = Option Premium − Intrinsic Value
Example
A call option with a $50 strike on a stock trading at $55, priced at a $7 premium, has $5 of intrinsic value and $2 of time value.
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In the money (ITM): has intrinsic value (call: stock > strike; put: stock < strike).
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At the money (ATM): stock price ≈ strike price.
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Out of the money (OTM): no intrinsic value — the entire premium is time value.
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→Common Options Strategies
Advanced
Beyond simply buying calls or puts, investors combine options to manage risk or generate income. These are more advanced techniques and generally not recommended until you're comfortable with the basics above.
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Covered call: owning shares and selling a call against them to collect premium income, capping upside in exchange for cash now.
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Protective put: owning shares and buying a put as 'insurance' against a price decline.
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Cash-secured put: selling a put while holding enough cash to buy the shares if assigned — often used to acquire stock at a discount.
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Spreads: buying and selling options of the same type at different strikes/expirations to limit both risk and reward.
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→The Greeks (Options Risk Measures)
Advanced
'The Greeks' are a set of measures that describe how an option's price is expected to react to different factors. Professional options traders use them to understand and manage risk precisely; beginners mainly need to recognize what each one represents.
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Delta: how much the option price moves for a $1 move in the stock (also used as a rough estimate of probability the option expires in the money).
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Gamma: how much Delta itself changes as the stock price moves.
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Theta: how much value the option loses each day purely from time decay.
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Vega: how sensitive the option price is to changes in implied volatility.
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Rho: how sensitive the option price is to changes in interest rates (usually the least impactful for short-term options).
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→PEG Ratio (Growth-Adjusted P/E)
Advanced
The PEG ratio refines the P/E ratio by factoring in expected earnings growth, making it easier to compare companies growing at different speeds. A high-growth company can 'deserve' a higher P/E than a slow-growth one — PEG tries to normalize for that.
Formula
PEG Ratio = P/E Ratio ÷ Expected Annual EPS Growth Rate (%)
Example
A stock with a P/E of 30 and expected earnings growth of 15% per year has a PEG of 2.0.
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A PEG around 1.0 is traditionally viewed as 'fairly valued' relative to growth; below 1.0 may suggest undervaluation.
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PEG is only as reliable as the growth estimate feeding it — overly optimistic projections distort the result.
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→Free Cash Flow (FCF) & FCF Yield
Advanced
Free cash flow is the actual cash a company generates after paying for the operating expenses and capital investments needed to run the business. Many analysts consider it a truer measure of financial health than net income, because it's harder to manipulate with accounting choices.
Formula
Free Cash Flow = Operating Cash Flow − Capital Expenditures
FCF Yield = Free Cash Flow per Share ÷ Share Price
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A company can show accounting profit (net income) while burning cash, or vice versa — FCF helps reconcile the two.
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FCF yield is often compared to a company's dividend yield or bond yields to judge relative attractiveness.
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→EV/EBITDA (Enterprise Value Multiple)
Advanced
EV/EBITDA is a valuation ratio that's especially useful for comparing companies with different debt levels or tax situations, because it looks at the whole business (including debt) rather than just the equity (share) price. It's widely used in mergers & acquisitions and cross-company comparisons.
Formula
Enterprise Value (EV) = Market Cap + Total Debt − Cash & Equivalents
EV/EBITDA = Enterprise Value ÷ EBITDA
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EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization — defined in detail in the Accounting guide.
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Lower EV/EBITDA relative to peers can suggest a stock is undervalued, all else equal.
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→Technical Indicators: RSI, MACD, Bollinger Bands
Advanced
Technical analysts use mathematical indicators derived from price and volume to gauge momentum and potential turning points. These don't measure business value — they measure trading behavior.
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RSI (Relative Strength Index): a 0–100 scale measuring recent price momentum; readings above 70 are often considered 'overbought', below 30 'oversold'.
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MACD (Moving Average Convergence Divergence): compares two moving averages to spot shifts in momentum and trend direction.
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Bollinger Bands: bands plotted above and below a moving average based on volatility; price touching the outer bands can signal an overextended move.
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→Short Selling & Margin
Advanced
Short selling means borrowing shares and selling them, betting the price will fall so they can be bought back later at a lower price and returned to the lender — profiting from the difference. Margin means borrowing money from a broker to buy securities. Both amplify potential gains, but also amplify potential losses — short selling in particular carries theoretically unlimited risk, since a stock's price has no upper limit.
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Short squeeze: when a heavily shorted stock rises sharply, forcing short sellers to buy back shares to limit losses, which pushes the price up further.
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Margin call: a broker's demand for more funds/collateral when an account's value falls below required maintenance levels.
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These are advanced, higher-risk techniques generally unsuitable for beginning investors.
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→Risk-Adjusted Return: The Sharpe Ratio
Advanced
Raw returns don't tell the whole story — a 15% return achieved with wild swings is very different from a 15% return achieved smoothly. The Sharpe ratio measures return earned per unit of risk (volatility) taken, making it possible to compare investments or portfolios on a risk-adjusted basis.
Formula
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) ÷ Standard Deviation of Portfolio Returns
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Higher Sharpe ratio = more return for each unit of risk taken.
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The 'risk-free rate' is typically approximated using short-term government Treasury yields.
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Useful for comparing funds or strategies, not just individual stocks.
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→Putting It Together: Building a Checklist
Advanced
No single ratio tells the whole story — experienced analysts triangulate across valuation (P/E, PEG, EV/EBITDA), profitability (margins, ROE), financial health (debt ratios, FCF), and momentum/technical context, then weigh it all against the price they'd have to pay today. Treat every formula in this guide as one input into a broader judgment call, not a standalone verdict.
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Start with the business: what does it do, and how does it make money?
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Check valuation relative to peers and history (P/E, PEG, EV/EBITDA, P/B).
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Check financial health (debt ratios, free cash flow, interest coverage).
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Check profitability trends (margins, ROE, ROIC) over multiple years, not just one quarter.
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Only consider options strategies once you're fully comfortable with the underlying stock fundamentals.
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