Options

History of Options

1630s, the Netherlands — This was the most critical period in the history of options. Tulips gradually became a symbol of wealth and social status, and under intense market speculation, prices began to fluctuate dramatically. Because tulips were highly seasonal, spot transactions could not always be executed at any time, so the need to agree on future transaction prices emerged.

Options were not originally created for speculation, but to help producers and buyers lock in future prices and reduce operational risk. Wholesalers, in order to secure input costs, paid growers a “premium” to obtain the right to buy tulips at a predetermined price in the future. This became the earliest form of commodity options. As more participants entered the market not to trade tulips, but to bet on price movements, options gradually evolved from a risk management tool into a speculative instrument.

• If market price > agreed price → exercise the option and buy at the lower price
• If market price < agreed price → do not exercise, only lose the premium

What started as a risk management tool turned into the “Tulip Mania” of 1636–1637 as speculators flooded the market. In February 1637, prices collapsed, and many put option sellers were unable to fulfill their obligations, causing the market to crash. The Dutch government subsequently banned speculative options trading, and options were stigmatized for a long time.

However, modern options markets have established exchanges, margin systems, and clearing mechanisms. They are fundamentally different from the informal over-the-counter contracts of that era, making today’s options markets far more regulated and secure.

Options

Why do options exist?

An option is essentially a “price insurance contract.” Its core purpose is not to predict the market, but to allow both parties to lock in future prices in advance, thereby reducing risks caused by price fluctuations.

For example, consider a noodle shop and a wheat farmer. The noodle shop needs to purchase large quantities of wheat flour every year. When harvests are poor, wheat supply decreases and prices usually rise; when harvests are abundant, supply increases and prices usually fall.

The shop owner wants to avoid situations where poor harvests cause wheat prices to surge, so they want cost stability. At the same time, the farmer wants to avoid situations where abundant harvests cause wheat prices to crash, leading to losses. This is where an insurance mechanism appears.

The noodle shop owner can pay a 100 yuan premium to an insurance company to guarantee that, no matter how much wheat prices rise next year, they can still buy wheat at 1000 yuan per 100 kg.
The farmer can also pay a 100 yuan premium to guarantee that, no matter how much wheat prices fall, they can still sell at 1000 yuan per 100 kg.

When the harvest arrives next year, both parties can trade at their desired prices.

It is important to note that the 100 yuan is not part of the future wheat purchase/sale. It is the cost paid to obtain the “right of choice,” and it is non-refundable even if the contract is not used.

If next year wheat is only 800 yuan on the market, the shop owner will not exercise the contract and will buy at the market price instead. If wheat rises to 1200 yuan, the farmer will also abandon the contract and sell at the market price.

This is because an option grants a right, not an obligation, allowing the holder to decide whether to execute the contract based on market conditions. The insurance company earns mainly from the premiums. In reality, insurers are willing to take such risks because large pools of clients allow risk to be diversified, and premiums cover long-term expected payouts.

This creates a balance: buyers reduce risk, while sellers earn premiums in exchange for bearing risk.

Mapping this to financial markets, this insurance is called an Option, and stock options do not change the underlying stock itself—they simply create a contract giving the right to buy or sell the stock in the future.

• The premium paid by the noodle shop and farmer is called the Premium — the price paid to acquire an option.
• The agreed price of 1000 yuan per 100 kg is called the Strike Price (Exercise Price) — it locks in the future buying or selling price of the asset. Once set, it usually does not change before expiration.
• The act of buying or selling at the agreed price is called exercising the option.
• Unlike the wheat example, in stock markets, option holders can exercise their rights any time before the Expiration Date.

How to use options

Depending on the direction of protection, stock options are mainly divided into two types: Call options and Put options.

In the previous example, the noodle shop and farmer were effectively buying two different types of options. In stock markets, the shop corresponds to a Call option (betting price goes up), while the farmer corresponds to a Put option (betting price goes down).

Both are “buying” actions, so they are considered Long positions. The counterparty, who sells the option (the insurance provider in this analogy), takes the Short position.

In modern markets, option sellers are not necessarily insurance companies; instead, they are traders willing to take on risk in exchange for premium income.

Most options in the market are provided by Market Makers. Because market makers must provide liquidity, brokers give them extremely low fees and privileged access. Their main role is to continuously quote buy and sell prices so that investors can always execute trades. Therefore, they do not simply bet on price direction; instead, they profit through continuous risk hedging and the Bid-Ask Spread.

For large liquid stocks like TSLA and AAPL, market makers can usually fill orders instantly. For small-cap stocks with low liquidity, spreads are wider and execution may be slower.

How institutions use options

For institutions, options are primarily a risk management tool, not just a speculative instrument.

1. Protective Put: An institution holding a large position in AAPL may remain bullish long-term but worry about short-term drops due to earnings reports. They buy Put options to offset potential losses in the underlying stock. This is similar to buying insurance for their portfolio.

2. Covered Call: An institution holding AAPL in a sideways market may sell Call options to collect premium income. This is similar to “renting out” the upside potential of the stock in exchange for steady cash flow.

How retail investors use options

1. Leveraged upside (Long Call): A Long Call allows investors to gain exposure to stock upside with limited capital. However, if the stock does not move as expected, the entire premium may be lost. Retail investors who want to bet on short-term gains in AAPL but lack sufficient capital can use Long Calls. Profit equals stock gain minus premium paid.

2. Buying on dips (Sell Put): Selling a Put allows investors to acquire stock at a lower price. If an investor wants to buy AAPL but thinks it is too expensive at current levels, they can sell a Put at $100. If the stock falls below$100, they are obligated to buy at $100; if it does not, they keep the premium. Therefore, selling Puts is more suitable for investors already willing to buy at lower prices.

For institutions, options become a precision financial tool ensuring portfolio protection during crises. For retail investors, options break capital constraints and provide access to more flexible strategies. However, users must fully understand both potential returns and risks before using them.

Options Mechanics

Before reading the following examples, note that option P&L is affected not only by price movement, but also by time to expiration, volatility, and premium cost. For simplicity, the following examples assume payoff at expiration only.

Long Call (Buy Call Option)

I expect the stock to rise from 100 to 120, so I buy a Call with strike price 120.

Assume a company stock price is 50, and we compare payoff structures:

Short Call (Sell Call Option)

I own 1 share of Apple stock and believe it will not rise above 120, so I sell a Call.

Long Put (Buy Put Option)

I expect the stock to fall from 100 to 80, so I buy a Put with strike price 80.

Short Put (Sell Put Option)

I believe the stock will not fall below 80, so I sell a Put.