How Stock Options Work: Calls, Puts, and Key Concepts

Key Takeaways

• Stock options give the holder the right, but not the obligation, to buy or sell shares at a specified price.
• Call options and put options serve different purposes depending on market expectations.
• Option value is influenced by time, volatility, and the relationship between the stock price and the strike price.

What Are Stock Options?

A stock option is a derivative contract whose value is based on an underlying stock. Instead of owning the stock itself, the option holder owns the right to transact shares under predefined conditions. These conditions include a fixed price, known as the strike price, and a fixed time period, ending on the expiration date.
Stock options are standardized contracts traded on regulated exchanges. Each option contract typically represents 100 shares of the underlying stock, and the contract terms are set when the option is created.

Call Options and Put Options

Stock options are divided into two main types: call options and put options.
A call option gives the holder the right to buy shares of the underlying stock at the strike price before the option expires. Call options are generally used when an investor expects the stock price to rise. If the market price exceeds the strike price, the option gains value.
A put option gives the holder the right to sell shares at the strike price before expiration. Put options are commonly used when an investor expects the stock price to decline. If the market price falls below the strike price, the put option becomes more valuable.
The seller, or writer, of an option takes on the obligation to buy or sell the shares if the option holder chooses to exercise the contract.

Strike Price and Expiration Date

The strike price and expiration date are central to how stock options work. The strike price determines the price at which shares can be bought or sold, while the expiration date defines how long the option remains valid.
As the expiration date approaches, an option’s time value generally decreases. This process, known as time decay, accelerates as expiration nears and plays a significant role in option pricing and strategy selection.

Option Premium and Value

The price paid to purchase a stock option is called the premium. This premium represents the cost of acquiring the rights embedded in the option contract and is paid by the buyer to the seller.
An option’s value consists of intrinsic value and time value. Intrinsic value reflects whether the option is currently profitable based on the stock’s market price relative to the strike price. Time value reflects the remaining potential for the option to become profitable before expiration.
Factors such as stock price movement, volatility, time to expiration, and interest rates all influence the premium.

Exercising and Trading Stock Options

Exercising a stock option means using the contractual right to buy or sell the underlying shares at the strike price. If a call option is exercised, the holder buys shares; if a put option is exercised, the holder sells shares.
In practice, many investors choose not to exercise options. Instead, they may sell the option contract in the market before expiration to realize gains or limit losses. This flexibility allows traders to benefit from price movements without engaging in the underlying stock transaction.

How Stock Options Are Used

Stock options serve several common purposes in financial markets.
For speculation, options allow investors to express directional views with less upfront capital than purchasing shares directly. Because the premium is typically lower than the cost of buying stock, options provide leveraged exposure.
For hedging, options are used to manage risk. Investors holding stocks may buy put options to protect against downside price movements, effectively setting a floor on potential losses.
For income strategies, some investors sell options to collect premiums. Covered calls, for example, involve selling call options on stocks already owned, generating income while limiting upside potential.

Risks Associated With Stock Options

While stock options offer flexibility, they also involve risks. Buyers risk losing the entire premium if the option expires worthless. Sellers may face substantial losses if the stock price moves sharply against their position.
Options pricing is influenced by multiple variables beyond price direction, including volatility and time decay. As a result, stock options require a deeper understanding than simple stock trading.

Frequently Asked Questions

What happens when a stock option expires?

If an option expires out of the money, it becomes worthless and the holder loses the premium paid. In-the-money options may be exercised or closed before expiration.

Do stock options represent ownership of shares?

No. Stock options provide rights related to shares but do not represent ownership unless the option is exercised.

Are stock options suitable for long term investing?

Stock options are typically used for short to medium term strategies due to expiration dates. Long term investing usually involves holding shares rather than options.

The Bottom Line

Stock options are derivative contracts that provide the right to buy or sell shares at a fixed price within a defined time period. Understanding how stock options work involves recognizing the roles of call and put options, strike prices, expiration dates, and option premiums. When used with a clear understanding of their mechanics and risks, stock options can serve as powerful tools for managing risk, expressing market views, and structuring investment strategies.