What a stock option is and what it gives you the right to do

A stock option is a contract that gives you the right — but not the obligation — to buy or sell shares of a specific stock at a set price on or before a certain date. You do not own the stock itself. Instead, you own the right to make a transaction at terms you agreed to in advance. That right has a price, called the premium, which you pay upfront when you buy the option.

Options exist because they let you control a larger position with less money than buying the stock outright. If a stock trades at $100 per share and you buy one option contract (which represents 100 shares), you might pay $200 to $500 in premium instead of $10,000 to own the shares directly. The tradeoff is that your option expires on a specific date, and if the stock does not move the way you predicted, you can lose your entire premium.

There are two basic types of options: a call and a put. A call gives you the right to buy. A put gives you the right to sell. The price at which you can buy or sell is called the strike price. The date your right expires is the expiration date.

Key Takeaways

  • A call option gives you the right to buy shares at a set price; a put option gives you the right to sell shares at a set price.
  • You pay a premium upfront to own an option, and that premium is the maximum you can lose if the option expires worthless.
  • Options expire on a specific date, and most options stop being tradeable a few days before that date.
  • The strike price is the price at which you can buy (call) or sell (put) the underlying stock if you exercise your option.
  • Options are leveraged: you control 100 shares per contract with a smaller cash outlay than buying shares directly.

How calls work: the right to buy at a locked-in price

When you buy a call option, you are paying for the right to buy 100 shares of a stock at the strike price anytime before the expiration date. If you own a call with a strike price of $50 and the stock rises to $70, your option is now worth at least $20 per share (or $2,000 per contract) because you can buy at $50 and the stock is worth $70. You can exercise the option (buy the shares), sell the option contract itself to someone else, or let it expire.

Calls are used by people who believe a stock will rise. If you are right and the stock climbs above your strike price by more than the premium you paid, you make money. If the stock stays flat or falls, you lose the premium you paid upfront. The maximum loss on a call is the premium; the maximum gain is theoretically unlimited because a stock can keep rising.

You do not have to exercise a call. Most options traders sell the contract before expiration rather than actually buying the shares. This is simpler and does not require the cash to purchase 100 shares.

How puts work: the right to sell at a locked-in price

When you buy a put option, you are paying for the right to sell 100 shares of a stock at the strike price anytime before the expiration date. If you own a put with a strike price of $50 and the stock falls to $30, your option is now worth at least $20 per share (or $2,000 per contract) because you can sell at $50 when the stock is only worth $30. You can exercise the option (sell the shares you own), sell the option contract itself, or let it expire.

Puts are used by people who believe a stock will fall or by people who already own shares and want to protect against a drop. If you own 100 shares of a stock trading at $60 and you buy a put with a $50 strike price, you have locked in a floor: no matter how far the stock falls, you can sell at $50. The premium you paid is the cost of that insurance.

Like calls, most put traders sell the contract before expiration rather than actually selling shares. Puts are also used by traders who do not own the stock at all but believe it will fall — they buy the put, and if the stock drops, they sell the put contract for a profit.

Strike price, expiration date, and how they affect an option's value

The strike price is the price at which you can buy (call) or sell (put) the stock. An option is in the money when it would be profitable to exercise it 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. An option is out of the money when exercising it would lose money compared to the current stock price.

The expiration date is when your right to buy or sell expires. Most stock options expire on the third Friday of each month, though some expire weekly. After the expiration date, the option is worthless and cannot be exercised. Most brokers stop letting you trade an option a few days before expiration because liquidity (the number of buyers and sellers) drops sharply.

An option loses value as it approaches expiration, especially if it is out of the money. This decay is called time decay. An option that is far from expiration and far out of the money might still have some value because there is time for the stock to move in your favor. The same option one day before expiration and still out of the money will be nearly worthless.

The difference between American and European options

Most stock options traded in the United States are American-style options, which means you can exercise them anytime between the purchase date and the expiration date. This flexibility is valuable because it lets you lock in a gain or cut a loss whenever you choose.

European-style options can only be exercised on the expiration date itself, not before. They are less common in stock trading but appear in some index options and currency options. For most stock options you will encounter, assume American-style unless you see otherwise in the contract details.

How option prices are set and what affects them

The premium you pay for an option depends on several factors. The most obvious is how far in or out of the money the option is. An in-the-money call is worth more than an out-of-the-money call on the same stock. The distance between the current stock price and the strike price matters: a call with a $50 strike is worth more when the stock is at $60 than when it is at $51.

Time to expiration also drives price. An option with three months until expiration is worth more than an identical option expiring in one week, because there is more time for the stock to move in your favor. Implied volatility — a measure of how much traders expect the stock to move — also matters. If traders expect wild price swings, options are more expensive because there is a higher chance the option will end up in the money. If traders expect the stock to barely move, options are cheaper.

The interest rate environment and whether the stock pays dividends also affect option prices, but these are smaller factors for most traders. Your broker will show you the current premium for any option contract, so you do not need to calculate it yourself.

Buying versus selling options, and the risk difference

When you buy an option, your maximum loss is the premium you paid. Your maximum gain is theoretically unlimited (for calls) or very large (for puts). Buying is simpler and is how most people start with options.

When you sell an option (also called writing an option), you receive the premium upfront but you take on the obligation to buy or sell the stock if the buyer exercises. Selling a call means you agree to sell 100 shares at the strike price if the buyer demands it. Selling a put means you agree to buy 100 shares at the strike price if the buyer demands it. Your maximum gain is the premium you collected. Your maximum loss can be very large or theoretically unlimited, depending on which option you sell.

Selling options requires more experience and usually requires your broker to approve you for options trading at a higher level. Most beginners start by buying options, not selling them.

Frequently Asked Questions

What happens if I do not exercise my option before it expires?

If you do not exercise an in-the-money option before expiration, most brokers will exercise it automatically for you on the expiration date. If your option is out of the money at expiration, it expires worthless and you lose the premium you paid. You can also sell the option contract anytime before expiration instead of exercising it.

Can I lose more money than the premium I paid?

If you buy an option, no — your loss is capped at the premium. If you sell an option, yes — your loss can be much larger than the premium you collected, especially if you sell a call on a stock that rises sharply or sell a put on a stock that falls sharply.

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. Buying a put on a stock you do not own is a bet that the stock will fall. If you own the stock, buying a put is a way to protect against a drop — it acts like insurance.

How much does an option contract cost?

Option premiums vary widely depending on the stock, the strike price, the expiration date, and market conditions. Premiums range from a few cents per share to several dollars per share. Since one contract represents 100 shares, a premium of $2 per share costs $200 total. Your broker will show you the current price for any option you are considering.

What is the difference between buying a call and buying the stock?

Buying a call costs less upfront and limits your loss to the premium, but the option expires and becomes worthless if the stock does not move enough. Buying the stock costs more upfront but you own it indefinitely and can hold it as long as you want. A call is leveraged — you control 100 shares with less money — but it is also riskier because of the expiration date.