What happens when you buy or sell an option
When you buy an option, you are paying a seller for the right to buy or sell a specific stock at a set price on or before a certain date. You do not own the stock itself — you own a contract. The seller (called the writer) collects your payment and takes on the obligation to sell you the stock (if you buy a call option) or buy it from you (if you buy a put option) at that price, whenever you choose to exercise that right.
The price you pay for the option is called the premium. This is not the price of the stock. It is the cost of the contract itself, and it reflects how likely the market thinks it is that your option will become valuable. If you never exercise the option, the seller keeps the premium and you lose what you paid. If you do exercise it, you get the right to transact at the agreed price, regardless of what the stock costs on the open market that day.
Options are traded on exchanges — the largest being the Chicago Board Options Exchange (CBOE) — just like stocks are. You need a brokerage account that permits options trading, and most brokers require you to pass a brief questionnaire about your experience before they allow you to trade them.
Key Takeaways
- An option is a contract giving you the right (not the obligation) to buy or sell a stock at a fixed price by a specific date, and you pay a premium upfront for that right.
- Call options let you buy at a set price; put options let you sell at a set price, and the seller of either type must fulfill the contract if you exercise it.
- The premium you pay depends on how far away the expiration date is, how far the stock price is from the strike price, and how volatile the stock has been.
- You can close an option position before expiration by selling it back to the market, which means you do not have to own or deliver the underlying stock.
- Most options expire worthless, and most traders close positions before expiration rather than exercising them and taking delivery of shares.
Calls and puts — the two types of options
A call option gives you the right to buy a stock at a set price (the strike price) by a set date (the expiration date). You buy a call when you think the stock price will rise above the strike price. If it does, you can exercise the option and buy the stock at the lower strike price, then sell it at the higher market price — or simply sell the option contract itself for a profit.
A put option gives you the right to sell a stock at the strike price by the expiration date. You buy a put when you think the stock price will fall below the strike price. If it does, you can exercise the option and sell the stock at the higher strike price, or sell the put contract for a profit.
When you sell (or write) a call, you are betting the stock will stay below the strike price. You collect the premium upfront, but you take on the obligation to sell the stock at that price if the buyer exercises. When you sell a put, you are betting the stock will stay above the strike price, and you must buy it at the strike price if the buyer exercises.
How the premium is calculated
The premium reflects three main factors. Time value means that an option expiring in six months is worth more than one expiring in two weeks, because there is more time for the stock to move in your favor. Intrinsic value is how much the option is worth right now if you exercised it immediately — a call with a strike of $50 on a stock trading at $55 has $5 of intrinsic value. Volatility means that a stock that swings wildly in price makes options more valuable, because there is a greater chance the option will end up in the money.
The market price of an option changes throughout the trading day as these factors shift. If the stock rises, a call option becomes more valuable and a put becomes less valuable. If the stock falls, the opposite happens. If the expiration date gets closer, time value shrinks. If the stock becomes more volatile, both calls and puts become more expensive.
Exercising an option versus closing the position
You have three choices when you own an option: exercise it, let it expire, or sell it back to the market before expiration. Most traders choose the third option. Selling the option contract closes your position and locks in a profit or loss without ever touching the underlying stock.
If you exercise a call, your broker will buy the shares at the strike price and deposit them into your account. You then own the stock and can hold it, sell it, or do anything else a shareholder can do. If you exercise a put, your broker will sell shares you own at the strike price. If you do not own the shares, most brokers will not let you exercise a put unless you have a margin account and they can short-sell on your behalf.
If you do nothing and the option expires, it simply ceases to exist. If it expired worthless (the stock never moved the way you bet it would), you lose the premium you paid. If it expired in the money, you may have the option automatically exercised by your broker, depending on your account settings and the broker's rules.
What "in the money" and "out of the money" mean
An option is in the money when exercising it would make you money right now. For a call, that means the stock price is above the strike price. For a put, it means the stock price is below the strike price. An option is out of the money when exercising it would lose you money — the stock price is below the strike for a call, or above it for a put.
An option is at the money when the stock price equals the strike price. This is the dividing line between profit and loss. Options that are deep in the money behave almost like owning the stock itself, because they have high intrinsic value and move dollar-for-dollar with the stock. Options that are far out of the money are cheap but unlikely to ever be worth anything.
Expiration dates and how they work
Most stock options expire on the third Friday of each month. Some brokers also offer weekly options that expire every Friday, and some stocks have options expiring on other days. The expiration date is the last day you can exercise the option. After the market closes on that day, any option that is out of the money becomes worthless.
If your option is in the money at expiration, most brokers will automatically exercise it for you unless you tell them not to. This means if you own a call that is in the money, your broker will buy the shares at the strike price and deposit them into your account. If you own a put that is in the money, your broker will sell shares you own (or short-sell if you do not own them and have margin enabled). Check your broker's specific rules, because some require you to opt in to automatic exercise.
Leverage and risk in options trading
Options offer leverage because you control a large number of shares with a small upfront payment. One call option contract typically controls 100 shares. If you pay $200 for a call, you have the right to buy 100 shares at the strike price — that is $200 in capital controlling potentially thousands of dollars of stock. If the stock moves in your favor, your percentage gain can be much larger than if you had bought the stock outright.
But leverage cuts both ways. If the stock moves against you, you can lose your entire premium. If you sell (write) options, your losses can be much larger than the premium you collected. A call writer whose stock soars can face losses equal to the stock's rise times 100 shares. A put writer who must buy shares at the strike price when the stock has crashed can face losses of thousands of dollars. This is why most brokers require experience and a higher account balance before allowing you to sell options.
Frequently Asked Questions
Do I have to own the stock to buy a put option?
No. You can buy a put on any stock, whether you own it or not. If you exercise a put and do not own the shares, your broker will short-sell them for you (if you have margin enabled) and deposit the proceeds into your account. Most traders simply sell the put contract for a profit rather than exercising it.
What happens if I sell a call and the stock price skyrockets?
You are obligated to sell the shares at the strike price, even if the stock is worth much more. If you do not own the shares, your broker will buy them at the market price and sell them to the call buyer at the lower strike price — you absorb the difference as a loss. This is why selling calls is riskier than buying them.
Can I sell an option I bought before expiration?
Yes. You can sell any option you own back to the market at any time during trading hours. The price you receive depends on how much time value and intrinsic value remain. If the option has moved in your favor, you can close the position and lock in a profit without ever exercising.
What if an option expires on a weekend or holiday?
Options always expire on a trading day. If the third Friday of the month falls on a holiday when the market is closed, expiration moves to Thursday. Your broker will tell you the exact expiration date when you trade the option.
How much money do I need to start trading options?
Most brokers require a minimum account balance to trade options, often $2,000 to $5,000, though this varies. Selling options typically requires a higher minimum. Check your broker's requirements before opening an account.