What an option contract is and how it differs from owning stock

An option is a contract that gives you the right—but not the obligation—to buy or sell a specific stock at a set price on or before a certain date. You do not own the stock itself. Instead, you own a contract that lets you control 100 shares of that stock for a premium (the price you pay upfront). The person or institution selling you the option collects that premium and takes on the obligation to complete the trade if you decide to exercise your right.

This is fundamentally different from buying stock. When you buy 100 shares of Apple at $150 per share, you own those shares and can hold them indefinitely. When you buy an option contract on Apple, you own the right to buy or sell 100 shares at a locked-in price, but only until the expiration date arrives. After that date, the contract expires and becomes worthless if you have not used it.

The locked-in price is called the strike price. The date the contract expires is the expiration date. The amount you pay to buy the contract is the premium. These three elements determine what the option is worth at any moment and whether it makes financial sense to exercise it.

Key Takeaways

  • An option contract gives you the right to buy (call) or sell (put) 100 shares at a set price before a set date, but you are not required to do so.
  • You pay a premium upfront to buy an option; the seller keeps that premium regardless of whether you exercise the contract.
  • The strike price is the locked-in price at which you can buy or sell; the expiration date is when the contract stops existing.
  • If the stock price moves in your favor, you can exercise the option and profit; if it moves against you, you can let the contract expire and lose only the premium you paid.
  • Options are leveraged—you control 100 shares with a smaller cash outlay than buying the stock itself—which means larger percentage gains or losses are possible.

Call options: the right to buy at a set price

A call option gives you the right to buy 100 shares of a stock at the strike price before the expiration date. You buy a call when you believe the stock price will rise above the strike price. If it does, you can exercise the option, buy the shares at the lower strike price, and either sell them when ready for a profit or hold them.

Example: You buy a call option on Microsoft with a strike price of $300 and an expiration date three months away. You pay $5 per share, or $500 total for the contract (since one contract controls 100 shares). If Microsoft stock rises to $320 before expiration, you can exercise the option, buy 100 shares at $300, and when ready sell them at $320 for a $20-per-share gain. After subtracting the $5 premium you paid, your net profit is $15 per share, or $1,500 on the contract. If Microsoft stock falls to $280, you straightforward let the contract expire. You lose only the $500 premium you paid; you are not forced to buy the shares at $300.

The seller of the call option (called the call writer) receives your $500 premium upfront. If you exercise the option, the seller must provide 100 shares at $300 each. If you do not exercise, the seller keeps the premium as profit.

Put options: the right to sell at a set price

A put option gives you the right to sell 100 shares of a stock at the strike price before the expiration date. You buy a put when you believe the stock price will fall below the strike price. If it does, you can exercise the option, sell the shares at the higher strike price, and lock in a profit.

Example: You buy a put option on Tesla with a strike price of $200 and an expiration date two months away. You pay $4 per share, or $400 total. If Tesla stock falls to $180 before expiration, you can exercise the option and sell 100 shares at $200 each—even though the market price is $180. If you already own 100 shares of Tesla, you sell them at $200 and pocket the difference. If you do not own the shares, you can buy them at $180 and when ready sell them at $200 through the option. After subtracting the $4 premium, your net profit is $16 per share, or $1,600. If Tesla stock rises to $220, you let the contract expire and lose only the $400 premium.

The seller of the put option (the put writer) receives your $400 premium. If you exercise, the seller must buy 100 shares from you at $200 each. If you do not exercise, the seller keeps the premium.

How option prices change before expiration

The premium you pay for an option is not fixed. It changes every trading day based on the stock price, the time remaining until expiration, and how volatile the stock is. If the stock price moves in your favor, the premium rises and your contract becomes more valuable. If it moves against you, the premium falls.

You do not have to hold an option until expiration. You can sell it back to the market at any time during trading hours. If you bought a call for $500 and the stock price rose, you might sell that same contract back for $1,200. You pocket the $700 difference without ever exercising the option or owning the stock. Conversely, if the stock price fell, you might sell the contract back for $100 to cut your losses rather than hold it until it expires worthless.

Time decay works against you as the expiration date approaches. An option loses value as expiration nears, even if the stock price stays the same. This is because there is less time for the stock to move in your favor. On the expiration date itself, the option is worth either the difference between the stock price and the strike price (if it is in the money) or zero (if it is out of the money).

In-the-money and out-of-the-money options

An option is in the money when exercising it would produce a profit. A call option is in the money if the stock price is above the strike price. A put option is in the money if the stock price is below the strike price. An option that is in the money has intrinsic value—the amount you would gain if you exercised it right now.

An option is out of the money when exercising it would produce a loss. A call option is out of the money if the stock price is below the strike price. A put option is out of the money if the stock price is above the strike price. An out-of-the-money option has no intrinsic value, but it still has time value—the possibility that the stock price will move in your favor before expiration.

An option is at the money when the stock price equals the strike price. At-the-money options have no intrinsic value but maximum time value, because the stock price could move either direction.

On the expiration date, only intrinsic value remains. If a call option has a strike price of $100 and the stock is trading at $105, the option is worth $5 per share ($500 for the contract). If the stock is at $95 or lower, the option expires worthless.

Leverage and risk in options trading

Options are leveraged instruments. You control 100 shares of stock with a smaller cash outlay than buying the stock itself. This magnifies both gains and losses. If you buy 100 shares of a $100 stock, you spend $10,000. If you buy a call option on that stock for $2 per share, you spend $200. If the stock rises to $110, your 100 shares gain $1,000 (a 10 percent return on $10,000). Your call option gains $8 per share, or $800 (a 400 percent return on $200).

The flip side is that you can lose money faster with options. Your maximum loss on a call option is the premium you paid—$200 in the example above. But that $200 represents a 100 percent loss of your investment. With stock, you can hold and wait for recovery. With an option, time decay and expiration work against you every day.

The seller of an option faces different risks. A call seller who does not own the stock (a naked call) faces theoretically unlimited losses if the stock price rises sharply. A put seller faces losses if the stock price falls sharply, because they must buy shares at the strike price. Sellers collect the premium upfront but take on the obligation to complete the trade.

How to exercise an option or let it expire

If you decide to exercise your option, you contact your broker and submit an exercise request. For a call, you pay the strike price times 100 and receive 100 shares. For a put, you deliver 100 shares and receive the strike price times 100 in cash. Your broker handles the mechanics and settles the trade within the standard settlement period (usually two business days).

Most options expire on the third Friday of the month. If you hold an option that is in the money at expiration, many brokers will automatically exercise it for you. If it is out of the money, it expires worthless and disappears from your account. You can also manually close the position by selling the option back to the market before expiration, which locks in either a profit or a loss depending on how the premium has moved.

Assignment is what happens when you are the seller of an option and the buyer exercises it. If you sold a call and the buyer exercises, you are assigned—you must deliver 100 shares at the strike price. If you sold a put and the buyer exercises, you are assigned—you must buy 100 shares at the strike price. Assignment can happen at any time while the option is in the money, not just at expiration.

Frequently Asked Questions

What is the difference between American and European options?

American options can be exercised at any time before or on the expiration date. European options can only be exercised on the expiration date itself. Most options traded on U.S. stock exchanges are American. The difference matters because American options have more flexibility and are generally worth more, but most traders close their positions before expiration anyway.

Can I lose more money than I paid for the option?

If you buy an option, your maximum loss is the premium you paid. You cannot lose more than that. If you sell an option, your losses can be much larger—potentially unlimited for a call seller or substantial for a put seller—because you have taken on the obligation to complete the trade at an unfavorable price.

What happens if I do not have enough money to exercise a call option?

Your broker will not let you exercise a call unless you have the cash or buying power to pay the strike price times 100. If you want to profit from a call without buying the shares, you sell the option contract back to the market instead of exercising it.

How do I know what strike price and expiration date to choose?

Strike price and expiration date depend on your outlook for the stock and your risk tolerance. A strike price closer to the current stock price costs more but has a higher probability of being in the money. A strike price further away costs less but requires a larger stock move to profit. A longer expiration date costs more but gives the stock more time to move. Shorter expirations cost less but expire faster.

Why would I sell an option instead of just buying stock?

Selling options generates income from the premium upfront, even if the stock price does not move. A call seller collects premium and keeps it if the stock stays below the strike price. A put seller collects premium and keeps it if the stock stays above the strike price. This strategy works when you believe the stock will stay within a range, but it requires you to accept the obligation to buy or sell shares if the stock moves against you.