An option is a contract that gives you the right, but not the obligation, to buy or sell a stock at a set price before a set date. Options can be used to speculate, to earn income or to protect a portfolio. They're also more complex and riskier than buying shares, so it pays to understand the basics first.
Key terms
- Call option: the right to buy a stock at a set price.
- Put option: the right to sell a stock at a set price.
- Strike price: the price at which you can buy or sell.
- Expiration date: the last day the option can be used.
- Premium: the price you pay for the option.
- Contract size: a standard US stock option covers 100 shares, so a premium quoted at $2.00 costs $200 per contract.
How a call works
Say a stock trades at $100 and you buy a call with a $105 strike expiring in two months, paying $3 per share ($300). If the stock rises to $115 by expiration, your call is worth about $10 per share ($1,000), a profit of $700. If the stock stays below $105, the call expires worthless and you lose the $300 premium. Calls profit when the stock rises enough to cover the premium.
How a put works
A put rises in value when the stock falls. If you buy a $95 put for $2 and the stock drops to $80, the put is worth about $15 per share. If the stock stays above $95, you lose the premium. Puts can be used to bet on a decline or to insure shares you already own.
Buying vs. selling options
When you buy an option, the most you can lose is the premium. When you sell (write) an option, you collect the premium but take on the obligation. Selling a call without owning the shares exposes you to unlimited losses, much like short selling.
Common beginner strategies
- Covered call: own 100 shares and sell a call against them to earn income. You give up gains above the strike.
- Protective put: own shares and buy a put to limit how far you can lose, like an insurance policy.
- Cash-secured put: sell a put on a stock you'd be happy to own, keeping enough cash to buy the shares if assigned.
Why options are risky
- Time decay: options lose value as expiration approaches, so the stock has to move enough, and soon enough.
- Volatility: option prices depend on how much the market expects the stock to move, which can change quickly, for example after earnings.
- Leverage: small stock moves create large percentage gains or losses.
Brokers require you to apply for options approval, and they grant levels based on your experience. Before trading options, make sure you're comfortable analyzing the underlying stock, and size every trade so a total loss of the premium is acceptable. The position size calculator can help.
This article is educational and not investment advice. Options involve significant risk and are not suitable for all investors.
Frequently asked questions
How much money do I need to trade options?
Buying a single option contract can cost anywhere from a few dollars to thousands, because each contract usually covers 100 shares. Brokers also require options approval based on your experience.
Can you lose more than you invest with options?
When you buy options, the most you can lose is the premium you paid. When you sell options without owning the shares or holding enough cash, losses can be much larger and, for uncovered calls, unlimited.
What's the difference between a call and a put?
A call gives the right to buy a stock at a set price and gains value when the stock rises; a put gives the right to sell and gains value when the stock falls.
StockEngine articles are for education only and are not investment advice. Some links may be affiliate links.