Options Trading Basics: Calls, Puts and How Options Work
An option is a contract that gives you the right, but not the obligation, to buy or sell an asset at a set price before or on a set date. You pay a price for that right, called the premium. Options let traders bet on price moves with less upfront money than buying the asset outright, but they come with their own risks, especially for beginners.
What are calls and puts?
There are two basic types of options:
- Call option: the right to buy an asset at a set price. Traders buy calls when they expect the price to rise.
- Put option: the right to sell an asset at a set price. Traders buy puts when they expect the price to fall, or to protect a position they already hold.
The key parts of an options contract
- Underlying asset: the stock, index or other asset the option is based on.
- Strike price: the price at which you can buy (call) or sell (put) the underlying asset.
- Expiration date: the last day the option can be used. After that, it expires.
- Premium: the price you pay to buy the option. It's the most a buyer can lose.
- Contract size: in the US, one standard equity option contract typically covers 100 shares of the underlying stock.
How does an options trade work? A simple example
Say a stock trades at $50. You buy a call option with a $55 strike price that expires in one month, paying a premium of $1 per share. Because one contract typically covers 100 shares, the total cost is $100.
- If the stock rises to $60 before expiration, your option is worth at least $5 per share ($60 − $55), or $500 per contract. After the $100 you paid, that's a profit, before costs.
- If the stock stays below $55, the option may expire worthless, and you lose the $100 premium.
This shows the appeal of options (a large potential gain on a small outlay) and the catch: you need the price to move far enough, fast enough, or you can lose the whole premium.
In the money, at the money, out of the money
- In the money (ITM): the option has value if used now. For a call, the stock price is above the strike; for a put, it's below.
- At the money (ATM): the stock price is at or near the strike.
- Out of the money (OTM): the option has no value if used now. OTM options are cheaper, but more likely to expire worthless.
What affects an option's price?
An option's premium depends on several factors:
- The underlying price compared to the strike.
- Time until expiration. Options lose value as expiration approaches, all else being equal. This is called time decay.
- Volatility. The more the market expects the price to move, the more options tend to cost.
- Interest rates and dividends, which play a smaller role.
Buying options vs selling options
- Buyers pay the premium. Their maximum loss is the premium paid.
- Sellers (also called writers) receive the premium. In exchange, they take on the obligation to buy or sell if the option is exercised. Some selling strategies carry very large or even unlimited potential losses.
Beginners usually start by learning how buying calls and puts works before considering more complex strategies.
The risks new options traders often underestimate
- Losing the whole premium. Many options expire worthless.
- Time decay. Being right about direction isn't enough if the move comes too late.
- Leverage. Small price moves create large percentage gains and losses, which can trigger emotional decisions.
- Overtrading. Cheap contracts make it tempting to trade too often and too large.
- Complexity. Multi-leg strategies are easy to misunderstand.
Because options move quickly and magnify results, they're also where emotions like greed and panic do the most damage. See Trading Psychology: Why It Matters More Than Your Strategy.
Key takeaways
- An option gives the right, but not the obligation, to buy (call) or sell (put) at a set price before a set date.
- Option buyers pay a premium, which is their maximum loss.
- Time decay and volatility have a big effect on option prices.
- Options magnify both gains and losses, so position sizing and discipline are essential.
Frequently asked questions
Are options riskier than stocks?
They can be. Options can lose all their value by expiration, and their leverage magnifies losses. Some option-selling strategies can lose more than the initial amount.
What happens when an option expires?
If it's in the money, it may be exercised or settled, depending on the type of option and your broker. If it's out of the money, it usually expires worthless.
Do I need a special account to trade options?
Most brokers require you to apply for options trading and assign an approval level based on your experience and the strategies you want to use.
This article is for educational purposes only and isn't financial advice. Options involve significant risk and aren't suitable for every trader.