Key takeaways
- An option gives its buyer the right, but not the obligation, to buy (a call) or sell (a put) an underlying asset at a fixed strike price by a set date.
- The seller, or writer, takes on the obligation to sell (call) or buy (put) if the contract is assigned, in exchange for the premium.
- A standard equity option covers 100 shares; buying one can lose the whole premium, and selling some options can lose far more.
- Equity options are generally American-style and can be exercised before expiry; in-the-money options are generally exercised automatically at expiration.
- Options require approval from your broker for a specific trading level, because some strategies involve substantial risk.
Options are a different kind of instrument from ordinary shares. FINRA describes an option as a derivative that conveys to its purchaser the right, but not the obligation, to buy or sell a set quantity of a particular asset at a fixed price by a set date. That "right, not obligation" is what makes options flexible, and the obligations on the other side of the contract are what can make them dangerous.
The vocabulary
| Term | Meaning |
|---|---|
| Underlying | The asset the option is based on, such as a stock or ETF |
| Call | The right to buy the underlying at the strike price |
| Put | The right to sell the underlying at the strike price |
| Strike price | The fixed price at which the option can be exercised |
| Expiration date | The last day the contract is valid |
| Premium | The price the buyer pays for the option |
| Writer | The seller, who receives the premium and takes on the obligation |
| Contract size | FINRA notes a standard equity option equals 100 shares |
FINRA states the obligations precisely: the seller of a call must sell the underlying at the strike price if assigned; the seller of a put must buy it.
A call, worked through
You buy one call on a stock at a $50 strike, expiring in two months, for a premium of $2.00 per share. Because the contract covers 100 shares, it costs $200 before fees.
| Stock price at expiration | Option value | Profit or loss |
|---|---|---|
| $45 | $0 (expires worthless) | −$200 |
| $50 | $0 | −$200 |
| $52 | $2 × 100 = $200 | $0 (break-even) |
| $56 | $6 × 100 = $600 | +$400 |
The most the call buyer can lose is the premium. The break-even is the strike plus the premium. Notice the second row: the stock did not fall, yet the whole premium was lost, because it did not rise enough before expiry.
A put, worked through
You buy one put at a $50 strike for $1.50 per share, $150 per contract.
| Stock price at expiration | Option value | Profit or loss |
|---|---|---|
| $52 | $0 | −$150 |
| $48.50 | $1.50 × 100 = $150 | $0 (break-even) |
| $44 | $6 × 100 = $600 | +$450 |
A put rises in value as the underlying falls. FINRA notes that options can play roles ranging from helping investors manage risk to increasing income from stock they already hold.
Expiration and exercise
FINRA explains several rules about expiry and exercise:
- Equity options are American-style: the holder can exercise at any time before expiry. Index options are generally European-style and cash-settled.
- In-the-money options are generally exercised automatically at expiration. For a call, that means the money to buy 100 shares per contract becomes due.
- Expiry schedules vary: traditional monthly options expire on the third Friday of each month; weekly options usually list with at least a week to run; and LEAPS are long-term options expiring up to two years and eight months out. Some traders follow zero-days-to-expiration (0DTE) strategies, opening positions on a contract's last day.
Before expiry, FINRA notes, a holder has three choices: exercise (for American-style contracts), sell the contract to close the position, or let it expire worthless. A seller can be assigned at any time on an equity option, which FINRA lists as assignment risk, and the risk rises the day before a stock's ex-dividend date, because holders of in-the-money calls may exercise early to collect the dividend.
The risks
FINRA's summary: options offer leverage, the ability to magnify the value of the premium you pay, but leverage can come with the risk of significant losses.
- Buyers can lose 100% of the premium, quickly. Time works against them: FINRA's glossary describes time decay, or theta, as the way an option's theoretical value erodes with the passage of time.
- Sellers collect a premium but take on obligations. Writing a call without owning the shares exposes the seller to the same open-ended risk as short selling; writing a put can oblige the seller to buy shares far above their market price.
- Margin. The SEC's margin bulletin notes brokers generally require a margin account to trade options, do not let you buy options with margin, but may allow margin to sell them, and that some option-selling strategies can lose more than the initial investment. See cash account versus margin account.
- Volatility drives option prices; volatility explained covers the measure.
- Binary options are all-or-nothing contracts that FINRA calls extremely risky, made riskier by fraudulent schemes, many based outside the US; see investment fraud red flags.
Approval comes first
FINRA explains that your broker must approve your account for a specific level of options trading, through an options agreement, because some strategies involve substantial risk. FINRA also points to the official disclosure document Characteristics and Risks of Standardized Options for the full picture.
The listing for Learn to Trade Stocks Beginner frames options the same way: contracts with their own risks, including leverage, time decay and substantial potential losses. It introduces options terminology alongside paper trading with virtual money. It is one of our education apps, and the investing basics hub has the related guides, including risk tolerance.
Good to know
Frequently asked questions
What is the difference between a call and a put?
How much can you lose buying an option?
How much can you lose selling an option?
Why does one options contract equal 100 shares?
Sources
- Options (opens in a new tab)FINRA — accessed
- Investor Bulletin: Understanding Margin Accounts (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Learn to Trade Stocks Beginner (store listing) (opens in a new tab)Google Play — accessed
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