Options

What Is an Option?

An option is a contract between a buyer and a seller. It gives the buyer the right, but not the obligation, to buy or sell an underlying asset at an agreed price within a set period. The agreed price is the strike price, and the date the contract ends is its expiration date. The buyer pays the seller a fee called a premium for this right. Stock options are the most common type, but options also exist on indexes, currencies, and commodities.

How Options Work

There are two basic types. A call option gives the holder the right to buy the underlying asset at the strike price. A put option gives the holder the right to sell it at the strike price. A buyer who finds the contract unprofitable can let it expire and lose only the premium. The seller, also called the writer, keeps the premium but must fulfill the contract if the buyer chooses to use it. US stock options typically cover 100 shares of the underlying stock.

At expiration, a call is generally worth the amount by which the stock price exceeds the strike price, and a put is worth the amount by which the strike price exceeds the stock price. Before expiration, an option's price also includes time value, which tends to shrink as the expiration date approaches.

Call profit per share at expiration, when the stock is above the strike price:

Profit = Stock Price − Strike Price − Premium

A Simple Example

Suppose a stock trades at $50 and an investor buys one call option with a $55 strike price for a premium of $2 per share. Because the contract covers 100 shares, the total cost is $200. If the stock rises to $62 by expiration, the option is worth $7 per share, or $700, for a profit of $500 before fees and taxes. If the stock stays below $55, the option expires worthless and the buyer's loss is limited to the $200 premium. This example is hypothetical and ignores commissions.

Why Options Matter and Their Risks

Investors use options for speculation, for hedging an existing stock position, and for generating income by selling options. Options offer leverage, meaning a small amount of money can control a larger position, but this works in both directions. Option prices respond to changes in the stock price, volatility, and time, so an option can lose value even when the stock moves in the expected direction. Sellers can face large losses, especially when they do not own the underlying shares. Options are complex instruments, and their risks are not always obvious from their price alone.