What an options contract actually is
An options contract is a legal agreement between two people: one who owns the right to buy or sell a stock at a set price, and one who sold that right. The contract specifies four things: which stock, what price you can buy or sell it at, how many shares (usually 100 per contract), and when the contract expires.
You do not own the stock itself when you own an options contract. You own the right to buy it or sell it. That right has a price — called the premium — which you pay upfront when you buy the contract. The premium is separate from the price you would pay if you actually bought the stock later.
Options trade on exchanges the same way stocks do. You place an order through a brokerage account, and the price moves based on what other traders are willing to pay. A contract that costs $2 per share means $200 total (since each contract covers 100 shares), and that $200 is what you lose if the contract expires worthless.
Key Takeaways
- A call option gives you the right to buy a stock at a set price; a put option gives you the right to sell it at a set price.
- You pay a premium upfront to own the contract, and that premium is the most you can lose if you hold it until expiration.
- The strike price is the price at which you can buy or sell; the stock price must move past that price plus the premium you paid for the contract to be profitable.
- Contracts expire on a specific date, and after that date the contract is worthless if you have not exercised it or sold it to someone else.
- You can close a position before expiration by selling the contract to another trader, which is how most options traders actually exit their trades.
Calls and puts: the two types of options
A call option gives you the right to buy a stock at a set price (called the strike price) before the expiration date. You buy a call when you think the stock price will go up. If the stock rises above the strike price plus the premium you paid, you make money.
A put option gives you the right to sell a stock at a set price before expiration. You buy a put when you think the stock price will go down. If the stock falls below the strike price minus the premium you paid, you make money.
The person who sold you the call or put is on the other side of the trade. If you buy a call, someone sold it to you — and they profit if the stock stays below the strike price. If you buy a put, the seller profits if the stock stays above the strike price. Both sides are betting on the stock's direction, but from opposite angles.
Strike price and how it determines profit or loss
The strike price is the price at which you can exercise the option — buy the stock (for a call) or sell it (for a put). It is set when the contract is created and does not change, even if the stock price moves.
For a call option to be profitable, the stock price must rise above the strike price by at least the amount of the premium you paid. If you buy a call with a $50 strike price and pay $2 per share ($200 total), the stock needs to reach $52 for you to break even. If it reaches $55, you are $300 ahead (the $5 gain minus the $2 premium).
For a put option, the stock price must fall below the strike price by at least the premium. If you buy a put with a $50 strike price and pay $2 per share, the stock needs to fall to $48 for you to break even. If it falls to $45, you are $300 ahead.
The strike price you choose determines your risk and potential reward. A strike price closer to the current stock price costs more premium but requires less movement to profit. A strike price far from the current price costs less premium but requires the stock to move much further.
Expiration dates and what happens when they arrive
Every options contract has an expiration date — the last day you can exercise the option or sell the contract to someone else. After that date, the contract is worthless and disappears. You cannot exercise it, and you cannot sell it.
Expiration dates vary. Most stock options expire on the third Friday of each month, though some brokerages offer weekly expirations. Index options and some other products have different schedules. When you buy a contract, you choose which expiration date you want — you might buy a contract that expires in two weeks, two months, or six months.
As expiration approaches, the premium shrinks even if the stock price does not move. This decay accelerates in the final days. A contract that was worth $200 with three months to go might be worth $50 with one week left, straightforward because there is less time for the stock to move in your favor.
How traders actually exit options positions
Most options traders do not hold contracts until expiration. Instead, they sell the contract to another trader before expiration arrives. This is how you close a position and lock in a profit or loss.
When you sell a contract you own, you receive the current market price for it. If you bought a call for $200 and the stock has moved in your favor, that same contract might now be worth $500. You sell it, pocket the $300 profit, and you are done — you never exercise the option and never buy the stock.
Selling before expiration is usually smarter than holding to expiration, because the contract retains some value as long as time remains. If you wait until the last day and the stock is only slightly in your favor, the contract might be worth almost nothing even though you are technically profitable.
Exercising an option: when you actually buy or sell the stock
If you own a call option and the stock price is above the strike price at expiration, you can exercise it — pay the strike price and receive 100 shares of the stock. If you own a put option and the stock price is below the strike price, you can exercise it — sell 100 shares at the strike price.
Most brokerages will automatically exercise an option if it is profitable at expiration, though you can request not to. If you exercise a call, you need enough cash in your account to pay for the shares (strike price times 100). If you exercise a put, you need to own the shares to sell.
Exercising is uncommon among options traders because selling the contract before expiration is usually more profitable. Exercising makes sense if you actually want to own the stock and the option was a cheaper way to buy it, or if you own the stock and sold a put as a way to lower your cost basis.
How options prices move and what affects them
An options contract's price (the premium) moves based on several factors. The most obvious is the stock price itself — if a stock rises, call options become more valuable and put options become less valuable. But the premium also changes based on how much time remains, how volatile the stock is, and what interest rates are.
Time decay works against you if you own an option. Every day that passes, the contract loses value straightforward because there is less time for the stock to move in your favor. This happens even if the stock price stays flat. Sellers of options benefit from time decay.
Volatility — how much the stock price swings — makes options more expensive. A stock that moves 2 percent a day has higher volatility than one that moves 0.5 percent a day, and options on the volatile stock cost more. This is because larger price swings create more opportunity for profit.
Frequently Asked Questions
What is the maximum amount I can lose if I buy an options contract?
The maximum loss is the premium you paid upfront. If you buy a call or put for $200 and the stock moves against you, the contract expires worthless and you lose the full $200. You cannot lose more than that amount because you are not obligated to exercise the option.
Can I sell an options contract I do not own?
Yes — this is called selling to open. You receive the premium upfront, but you are now obligated to buy or sell the stock if the buyer exercises the contract. Selling options you do not own carries different risks than buying them, because your potential loss is not limited to the premium you received.
What happens if I own a call option and the stock splits?
The exchange adjusts the contract terms. If a stock splits 2-for-1, the strike price is halved and the contract now covers 200 shares instead of 100. The total value of your position stays roughly the same, but the per-share numbers change.
Do I need to own the stock to buy a put option?
No. You can buy a put on any stock, whether you own it or not. If you own the stock, it is called a protective put. If you do not own it, it is called a naked put, and you are betting the stock price will fall.
How do I know what strike price to choose?
Strike prices closer to the current stock price cost more premium but require less stock movement to profit. Strike prices far from the current price cost less but require bigger moves. Your choice depends on how much you want to spend and how much you think the stock will move.