What stock options trading is

Stock options trading is buying and selling contracts that give you the right — but not the obligation — to buy or sell a specific stock at a set price by a certain date. You do not own the stock itself. Instead, you own a contract that lets you control 100 shares of that stock (one standard options contract) for a premium you pay upfront.

The two basic types are call options, which give you the right to buy a stock at a fixed price, and put options, which give you the right to sell a stock at a fixed price. Traders use options to bet on whether a stock price will rise or fall, to hedge against losses in stocks they already own, or to generate income by selling options to other traders.

Options have an expiration date — typically ranging from days to months away — after which the contract becomes worthless if you have not used it. The price at which you can buy or sell the stock is called the strike price. The amount you pay to buy an option is called the premium.

Key Takeaways

  • A stock option contract gives you the right to buy (call) or sell (put) 100 shares of a specific stock at a set price before the expiration date.
  • You pay a premium upfront to buy an option, and that premium is the most you can lose if the trade goes against you.
  • Options expire on a specific date, and if you do not buy or sell the stock by then, the contract becomes worthless.
  • The strike price is the fixed price at which you can buy or sell the stock, and it determines whether an option has value when it expires.
  • Most individual traders buy and sell options contracts rather than exercising them to actually buy or sell the underlying stock.

Call options versus put options

A call option is a contract to buy 100 shares of a stock at the strike price. You buy a call when you expect the stock price to rise. If the stock price goes above the strike price plus the premium you paid, you make money. For example, if you buy a call option with a $50 strike price for a $2 premium, the stock needs to rise above $52 for you to break even. If it reaches $60, you can sell the contract for a profit or exercise it to buy 100 shares at $50 and when ready sell them at $60.

A put option is a contract to sell 100 shares of a stock at the strike price. You buy a put when you expect the stock price to fall. If the stock price drops below the strike price minus the premium you paid, you make money. If you own 100 shares of a stock trading at $60 and you buy a put option with a $50 strike price for a $2 premium, you are protected if the price falls below $48. You can sell your shares at $50 even if the market price is lower.

The person who sells you the option (the option writer) takes the opposite side of the bet. When you buy a call, someone sells it to you, betting the stock will not rise enough. When you buy a put, someone sells it to you, betting the stock will not fall enough. The seller keeps the premium you paid, but they face unlimited risk on calls and significant risk on puts.

How premiums and strike prices affect value

The premium is what you pay to buy an option contract, quoted per share but multiplied by 100 for the full contract. If a call option has a premium of $3, you pay $300 to control 100 shares. The premium reflects the probability that the option will be worth money at expiration, how far away expiration is, and how volatile the stock is. Options on stocks that move sharply in price have higher premiums because there is a greater chance they will end up profitable.

The strike price determines the fixed price at which you can buy or sell. A call option with a $50 strike price lets you buy the stock at $50 no matter what the market price is. A put option with a $50 strike price lets you sell the stock at $50. Strike prices are set at regular intervals — typically $1, $2.50, or $5 apart depending on the stock price — and you choose which strike price to buy or sell.

Options that are in the money have intrinsic value right now. A call is in the money if the stock price is above the strike price. A put is in the money if the stock price is below the strike price. Options that are out of the money have no intrinsic value — a call with a $50 strike is out of the money if the stock trades at $48, and a put with a $50 strike is out of the money if the stock trades at $52. Out-of-the-money options are cheaper because they have a lower probability of ending up profitable.

Time decay and expiration

Every option has an expiration date, usually the third Friday of the month for standard monthly options, though weekly options expire every Friday. After that date, the contract is worthless and cannot be exercised. The time remaining until expiration is called time value, and it shrinks every day. An option that expires in six months has more time value than one that expires in one week, so it costs more.

As expiration approaches, the rate at which an option loses value accelerates — a phenomenon called theta decay. An option that is out of the money loses value faster as expiration nears because there is less time for the stock to move in your favor. This is why most traders close out their options positions before expiration rather than holding until the last day. If you hold an out-of-the-money option until expiration, it expires worthless and you lose the entire premium you paid.

If you hold an option until expiration and it is in the money, most brokers will automatically exercise it for you — meaning they will buy or sell the underlying stock at the strike price. You can also manually exercise an option at any time before expiration, though most traders straightforward sell the contract to close the position instead.

How traders use options instead of owning stock

Most people who trade options never actually buy or sell the underlying stock. Instead, they buy and sell the options contracts themselves. If you buy a call option for $300 and the stock rises, the option becomes more valuable and you can sell it for $500, pocketing a $200 profit without ever owning the stock. This is called closing the position.

Options allow you to control a larger amount of stock with less money upfront. One call option contract controls 100 shares, so a $3 premium costs $300 but gives you exposure to $5,000 worth of stock (if the stock trades at $50). If the stock rises 10 percent, your $300 investment might double or triple because the option's value increases faster than the stock price. This is called leverage, and it cuts both ways — if the stock falls, you can lose your entire $300 premium.

You can also sell options you do not own, a strategy called selling to open. You receive the premium upfront and keep it if the option expires worthless. For example, if you sell a call option for a $2 premium, you collect $200 when ready. If the stock stays below the strike price at expiration, you keep the $200 and the contract expires. If the stock rises above the strike price, you may be forced to sell 100 shares at the strike price, even if you do not own them (this is called a short call).

Risk and the maximum loss on options

When you buy an option, your maximum loss is the premium you paid. If you buy a call for $300 and the stock falls to zero, you lose $300 and nothing more. You cannot lose more than you invested because you have no obligation to exercise the option — you straightforward let it expire worthless. This defined risk is one reason options attract traders who want to limit their downside.

When you sell an option, your risk is much larger. If you sell a call option, your loss is theoretically unlimited because the stock price can rise indefinitely. If you sell a call with a $50 strike for a $2 premium and the stock rises to $100, you are forced to sell 100 shares at $50 when they are worth $100, losing $5,000 (minus the $200 premium you collected). If you sell a put option, your maximum loss is the strike price times 100 minus the premium you collected — if you sell a $50 put for a $2 premium and the stock falls to zero, you lose $4,800.

Options are leveraged instruments, meaning small moves in the stock price can create large percentage gains or losses in the option's value. An option that is far out of the money can expire worthless even if the stock moves slightly in your favor, because the move was not large enough to bring the option into the money. Conversely, an option that is deep in the money can lose most of its value if the stock reverses direction.

Frequently Asked Questions

What is the difference between buying and selling options?

When you buy an option, you pay a premium upfront and your maximum loss is that premium. You profit if the stock moves in your direction enough to offset the premium. When you sell an option, you collect the premium when ready but face larger potential losses if the stock moves against you. Sellers profit if the stock does not move much or moves against the buyer's bet.

Can I exercise an option before the expiration date?

Yes, you can exercise an option at any time before expiration. However, most traders close out their positions by selling the option contract instead of exercising it, because selling captures the remaining time value. Exercising is more common for put options held as insurance on a stock you own.

What happens if I own a call option and the stock splits?

The option contract is adjusted to reflect the split. If you own a call option on a stock that splits 2-for-1, your strike price is halved and your contract now controls 200 shares instead of 100. The total value of your position remains the same, but the per-share terms change.

How do I know if an option is a good trade?

That depends on your outlook for the stock, how much time remains until expiration, and how much you are willing to risk. Options with more time value cost more but have a better chance of moving in your favor. Options closer to expiration are cheaper but require the stock to move faster. There is no single "good" trade — it depends on your prediction and risk tolerance.

Why do options expire on Friday?

Standard equity options expire on the third Friday of each month because that is when the Options Clearing Corporation settles all contracts. Weekly options expire every Friday. The expiration time is 4:00 p.m. Eastern Time, after the stock market closes, so the final stock price is locked in at the close of trading that day.