An option is a standardized contract that gives the buyer the right, but not the obligation, to buy or sell an underlying stock or ETF at a fixed price on or before a fixed date. The seller (the "writer") takes on the matching obligation.
The four terms on every contract
- Underlying: the stock or ETF, for example AAPL or SPY. One standard US equity option covers 100 shares (the multiplier).
- Type: a call is the right to buy; a put is the right to sell.
- Strike price: the price at which you can buy (call) or sell (put).
- Expiration: the last day the contract exists. Most US stock options stop trading at 4:00 PM ET on the expiration day, usually a Friday. Many large names now also have weekly and even daily expirations.
Premium. The price of an option is quoted per share. A quote of $2.35 costs $235 for one contract ($2.35 × 100), plus any commission. The buyer pays the premium; the seller receives it.
Four basic positions
- Long call (buy a call): you profit if the stock rises above strike + premium. Max loss is the premium.
- Long put (buy a put): you profit if the stock falls below strike − premium. Max loss is the premium.
- Short call (sell a call): you keep the premium if the stock stays below the strike. Without shares to cover it, risk is unlimited.
- Short put (sell a put): you keep the premium if the stock stays above the strike. Risk is the stock going to zero, minus the premium.
Worked example. AAPL trades at $180. You buy one 30-day $185 call for $3.00 ($300).
- AAPL at $195 at expiration: the call is worth $10 ($1,000). Profit $700.
- AAPL at $187: the call is worth $2 ($200). Loss $100, even though the stock went up. You needed $188 to break even.
- AAPL at or below $185: the call expires worthless. Loss $300, and no more.
Exercise and assignment. The buyer can exercise to actually buy (call) or sell (put) the shares at the strike. US stock options are American-style: they can be exercised any day before expiration. Most index options, such as SPX, are European-style (exercise only at expiration) and cash-settled. When a buyer exercises, a seller is randomly assigned and must deliver. At expiration, options that are $0.01 or more in the money are exercised automatically unless the holder says otherwise.
In practice, most traders never exercise. They sell the option back before expiration to collect whatever it's worth, which also captures any time value left.
Key takeaways
- Buying options: risk is limited to the premium. Selling options: you collect premium but take on an obligation.
- Always multiply by 100. A "cheap" $0.50 option is still $50 per contract.
- Being right on direction is not enough. The stock has to move past breakeven before expiration.