Options
What Are Options? Calls and Puts Explained With Real Numbers
An option is a contract that gives you a right, but not an obligation, to buy or sell a stock at a set price before a set date. That flexibility has a price, and the price can go to zero.
Two types: calls and puts
- A call option gives the buyer the right to buy shares at a set price. Call buyers generally profit if the stock rises.
- A put option gives the buyer the right to sell shares at a set price. Put buyers generally profit if the stock falls.
For every buyer there is a seller (also called the writer). The buyer pays a price, the premium, for the right. The seller collects the premium and takes on the obligation to buy or sell if the buyer exercises.
The terms of the contract
| Term | Meaning |
|---|---|
| Underlying | The stock (or ETF or index) the option is based on |
| Strike price | The price at which the stock can be bought (call) or sold (put) |
| Expiration date | The last day the option can be exercised |
| Premium | The price of the option, quoted per share |
| Contract size | Standard U.S. equity options generally cover 100 shares |
Reading a quote. "XYZ June 105 call at $3.00" means a call on XYZ stock, strike $105, expiring in June, priced at $3.00 per share. One contract costs $3.00 × 100 = $300.
A call, worked through
XYZ trades at $100. You buy one June 105 call for $3.00, paying $300.
- At expiration, XYZ is at $115. The call lets you buy at $105 something worth $115: $10 of value per share, or $1,000. Subtract your $300 cost: $700 profit.
- XYZ is at $108. The call is worth $3 per share, $300. You break even (before fees).
- XYZ is at $104 or anywhere below $105. No one would pay $105 for a stock worth less. The call expires worthless: $300 loss, 100% of what you paid.
Call breakeven at expiration = strike + premium = $105 + $3 = $108
A put, worked through
XYZ trades at $100. You buy one June 95 put for $2.50, paying $250. If XYZ falls to $85, you can sell at $95 something worth $85: $10 per share, $1,000, minus $250 = $750 profit. If XYZ stays above $95, the put expires worthless and you lose $250.
Put breakeven at expiration = strike − premium = $95 − $2.50 = $92.50
Investors who own a stock sometimes buy puts as insurance against a fall, accepting the premium as the cost of protection.
In, at and out of the money
- In the money: a call with a strike below the stock price, or a put with a strike above it. It has intrinsic value.
- At the money: strike roughly equal to the stock price.
- Out of the money: a call with a strike above the stock price, or a put with a strike below it. Its price is all time value.
What makes up the premium
Premium = intrinsic value + time value
Intrinsic value is what the option would be worth if exercised now. Time value is what buyers pay for the chance the option becomes more valuable before expiration. Time value depends mostly on how long until expiration and on implied volatility, the market's expectation of how much the stock will swing. Time value shrinks as expiration approaches, a process called time decay.
American and European style
Most U.S. stock options are American-style: they can be exercised any time before expiration. Many index options are European-style: they can be exercised only at expiration. Either way, most option holders close their positions by selling the option rather than exercising it.
Before you trade
Brokers must approve your account for options and provide the official disclosure document, Characteristics and Risks of Standardized Options. Read it. Then read our guide to the risks of options, and model any trade first:
Options payoff calculatorSee profit and loss at expiration for a long call, long put or covered call.
Common questions
How many shares does one option contract control?
A standard U.S. equity option contract generally covers 100 shares of the underlying stock, so the quoted premium is multiplied by 100 to get the contract's cost.
What is the most you can lose buying an option?
When you buy a call or a put, the most you can lose is the premium you paid, plus commissions and fees. That can be 100% of the amount invested.
What happens to an option at expiration?
An option that is in the money by a certain threshold is generally exercised automatically at expiration unless you instruct your broker otherwise. An out-of-the-money option generally expires worthless.
Do I need approval to trade options?
Yes. Brokers must approve your account for options trading and provide the options disclosure document, Characteristics and Risks of Standardized Options, before you trade.