What an option is and why traders use them

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 by a certain date. You pay a small upfront cost called a premium to own that right. The stock itself is called the underlying asset.

Traders use options for two main reasons: to bet that a stock price will move in a particular direction without buying the full stock, or to protect a stock they already own against a price drop. Because options cost much less than buying 100 shares outright, a small price movement in the stock can create a larger percentage gain or loss on the option itself.

Options are traded on exchanges like the Chicago Board Options Exchange (CBOE). Each option contract covers 100 shares of the underlying stock, though you buy and sell them one contract at a time.

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 a stock at a set price.
  • You pay a premium upfront to own an option, and that premium is the most you can lose if the trade goes against you.
  • The strike price is the price at which you can buy or sell the stock, and the expiration date is when the option contract ends.
  • Options let you control a larger position with less money than buying the stock outright, but the contract expires and becomes worthless if you do not use it.

Call options: the right to buy

A call option gives you the right to buy a stock at a specific price (called the strike price) on or before a specific date (called the expiration date). You would buy a call if you think the stock price will go up.

Here is a concrete example: You buy a call option on Apple stock with a strike price of $150 and an expiration date three months away. You pay $5 per share, or $500 total (since one contract covers 100 shares). If Apple stock rises to $160 before expiration, your right to buy at $150 is now worth $10 per share. You can sell that option contract for roughly $1,000, pocketing a $500 gain on your $500 investment. If Apple stock stays below $150 or falls, the option expires worthless and you lose the $500 premium you paid.

You do not have to actually buy the stock. Most traders sell the option contract before expiration rather than exercising it (actually buying the shares).

Put options: the right to sell

A put option gives you the right to sell a stock at a specific strike price on or before expiration. You would buy a put if you think the stock price will fall, or if you own the stock and want to protect yourself against a drop.

Example: You own 100 shares of Microsoft trading at $300 per share. You are worried about a price drop but do not want to sell the shares yet. You buy a put option with a strike price of $290 and pay $3 per share ($300 total). If Microsoft falls to $270, your right to sell at $290 is now worth $20 per share. You can sell that put contract for roughly $2,000, offsetting most of your loss on the stock itself. If Microsoft stays above $290, the put expires worthless and you lose the $300 premium—but you still own the stock.

Puts act like insurance: you pay a small premium to protect against a big loss, and if the loss does not happen, the insurance expires unused.

Strike price and expiration date

The strike price is the price at which you can buy (for a call) or sell (for a put) the underlying stock. It is fixed when you buy the option and does not change. Strike prices are usually set in $1 or $2.50 intervals depending on the stock price.

The expiration date is when the option contract ends. Most stock options expire on the third Friday of each month, though some expire weekly. After expiration, the contract is worthless and you can no longer use it. You must decide whether to sell the option, exercise it, or let it expire before that date arrives.

Options that are "in the money" (where the stock price is above the strike for a call, or below the strike for a put) have real value. Options that are "out of the money" (where the stock price is below the strike for a call, or above the strike for a put) are worth only their remaining time value, and that value shrinks as expiration approaches.

How the premium works

The premium is the price you pay to buy an option contract. It is quoted per share, so you multiply by 100 to get the total cost. A premium of $2 means you pay $200 to control 100 shares.

The premium depends on four main factors: how far the stock price is from the strike price, how much time is left until expiration, how volatile (jumpy) the stock is, and the overall interest rate environment. An option with more time left costs more because there is more chance the stock will move in your favor. An option on a volatile stock costs more because big price swings are more likely.

The premium is the maximum you can lose on an option trade. If you buy a call for $500 and the stock never rises, you lose $500 and nothing more. You cannot lose more than you paid upfront.

Why options carry risk

Options expire. If you buy a call expecting the stock to rise and it does not rise enough before expiration, the option becomes worthless and you lose your entire premium. This is different from owning stock, where you can hold it indefinitely and wait for a recovery.

Options also move faster than stocks. A 5% move in the stock price can create a 50% move in the option price, especially if expiration is near. This leverage cuts both ways: small moves can create big gains, but they can also wipe out your premium quickly.

If you sell an option (rather than buy one), your risk is much larger. When you sell a call, you are agreeing to sell the stock at the strike price if the buyer exercises. If the stock soars, you miss out on those gains. When you sell a put, you are agreeing to buy the stock at the strike price if the buyer exercises. If the stock crashes, you are forced to buy at a price well above the current market.

How to read an options chain

An options chain is a table showing all the available call and put options for a stock, organized by strike price and expiration date. Most brokers display it on their trading platform.

Each row shows one strike price. For that strike, you will see the call option and the put option side by side. The columns show the premium (bid and ask price), the number of contracts traded that day (volume), how many are currently open (open interest), and the implied volatility (a measure of how much the market expects the stock to move).

To find an option to trade, you pick an expiration date first, then scan the strike prices. Calls closer to the current stock price cost more but have a higher chance of ending in the money. Calls far above the stock price cost less but need a bigger move to profit. The same logic applies to puts.

Frequently Asked Questions

What happens if I buy a call and the stock price stays flat?

The option loses value as expiration approaches, even if the stock does not move. You lose money on the premium you paid, though the loss is limited to that amount. This is called time decay, and it accelerates in the final weeks before expiration.

Can I sell an option I bought before expiration?

Yes. Most traders sell their options before expiration rather than exercising them. You can sell at any time during market hours as long as there are buyers. The price you get depends on how much time is left and how far the stock has moved.

What is the difference between American and European options?

American options can be exercised any time up to expiration. European options can only be exercised on the expiration date itself. Most stock options traded in the U.S. are American. The difference rarely matters for traders who sell before expiration, but it matters if you plan to exercise.

Do I need to own the stock to buy a put option?

No. You can buy a put on any stock you do not own, betting that the price will fall. This is called a naked put. However, if the stock falls and you exercise the put, you will be forced to buy 100 shares at the strike price, so make sure you have the cash available.

How much money do I need to start trading options?

Most brokers require a minimum account balance to trade options, typically $2,000 to $5,000, though this varies. Some brokers also require you to pass an options approval process where you answer questions about your experience and risk tolerance. The minimum varies by broker and by the type of options trading you want to do.