Stock options give you the right to buy or sell shares at a specific price before a specific date. They are contracts, not shares. That distinction changes everything about how they work, how they are priced, and how they can lose you money. Options are one of the most flexible instruments in trading, but that flexibility comes with complexity. This guide breaks down the fundamentals: what calls and puts actually are, how pricing works, and what happens to your money in different scenarios.
What Is a Stock Option?
An option is a contract between two parties. The buyer pays a fee (called the premium) for the right — but not the obligation — to buy or sell 100 shares of a stock at a set price (the strike price) before or on a specific date (the expiration date).
That "right but not obligation" part is critical. If you buy shares of a stock and the price drops, you are sitting on a loss. If you buy an option and the trade does not work out, you can simply let the contract expire. Your maximum loss is the premium you paid. Nothing more.
There are two types of options: calls and puts. Everything else in options trading is built on those two building blocks.
Calls vs. Puts
Call Options
A call option gives the buyer the right to buy 100 shares at the strike price before expiration. You buy a call when you think the stock price will go up.
Example: Stock XYZ is trading at $100. You buy a call option with a $105 strike price expiring in 30 days, and you pay a $3.00 premium. That costs you $300 total (since each contract covers 100 shares). If XYZ rises to $115 before expiration, your option is worth at least $10.00 per share ($115 minus $105 strike). You paid $3.00, so your profit is $7.00 per share, or $700 on a $300 investment.
If XYZ stays below $105, your option expires worthless. You lose the $300 premium. That is it.
Put Options
A put option gives the buyer the right to sell 100 shares at the strike price before expiration. You buy a put when you think the stock price will go down.
Example: Stock XYZ is at $100. You buy a put with a $95 strike price for a $2.50 premium ($250 total). If XYZ drops to $85, your put is worth at least $10.00 per share ($95 minus $85). You paid $2.50, so your profit is $7.50 per share, or $750.
If XYZ stays above $95, the put expires worthless and you lose $250.
Key Terminology
Options have their own vocabulary. Here is a reference table for the terms you will encounter constantly.
Options Terminology Glossary
| Term | Definition |
|---|---|
| Strike Price | The price at which you can buy (call) or sell (put) the underlying shares |
| Premium | The price you pay to buy an option contract, quoted per share |
| Expiration Date | The last day the option is valid. After this, the contract ceases to exist |
| In the Money (ITM) | Call: stock price is above the strike. Put: stock price is below the strike |
| Out of the Money (OTM) | Call: stock price is below the strike. Put: stock price is above the strike |
| At the Money (ATM) | Stock price is roughly equal to the strike price |
| Exercise | Using your right to buy (call) or sell (put) the shares at the strike price |
| Assignment | The obligation given to an option seller when the buyer exercises |
| Intrinsic Value | The real, tangible value: how far ITM the option is. OTM options have zero intrinsic value |
| Extrinsic Value | The portion of the premium above intrinsic value, driven by time remaining and volatility |
Intrinsic vs. Extrinsic Value
An option's premium is made up of two components: intrinsic value and extrinsic value.
Intrinsic value is straightforward. If you hold a $100 call and the stock is at $108, the intrinsic value is $8.00. That is the built-in profit if you exercised right now. If the stock is at $97, the intrinsic value is zero — you would not exercise a right to buy at $100 when shares trade for less.
Extrinsic value is everything else: time until expiration, implied volatility, and interest rates. An option with 60 days left will have more extrinsic value than the same option with 5 days left, because there is more time for the stock to move. This is why options lose value as expiration approaches — a phenomenon called time decay.
As a buyer, time decay works against you every single day. The option bleeds value even if the stock does not move. This is one of the biggest reasons beginners lose money with options: they are right about the direction but wrong about the timing.
Call Option P&L Example
Let us walk through a concrete scenario. You buy 1 call option on stock XYZ: $105 strike, 30 days to expiration, $3.00 premium ($300 total cost). Here is what your profit or loss looks like at various stock prices at expiration.
Call Option P&L at Expiration ($105 Strike, $3.00 Premium)
| Stock Price at Expiration | Option Value (per share) | Cost (per share) | P&L per Contract |
|---|---|---|---|
| $95 | $0.00 | $3.00 | -$300 |
| $100 | $0.00 | $3.00 | -$300 |
| $105 | $0.00 | $3.00 | -$300 |
| $108 | $3.00 | $3.00 | $0 (breakeven) |
| $110 | $5.00 | $3.00 | +$200 |
| $115 | $10.00 | $3.00 | +$700 |
| $120 | $15.00 | $3.00 | +$1,200 |
Notice the breakeven point is $108, not $105. You need the stock to move past the strike plus the premium you paid before you make a dime. Below $105, your loss is capped at $300 regardless of how far the stock drops. Above $108, your profit grows dollar-for-dollar with the stock price.
Put Option P&L Example
Now the bearish side. You buy 1 put option on stock XYZ: $95 strike, 30 days to expiration, $2.50 premium ($250 total cost).
Put Option P&L at Expiration ($95 Strike, $2.50 Premium)
| Stock Price at Expiration | Option Value (per share) | Cost (per share) | P&L per Contract |
|---|---|---|---|
| $80 | $15.00 | $2.50 | +$1,250 |
| $85 | $10.00 | $2.50 | +$750 |
| $90 | $5.00 | $2.50 | +$250 |
| $92.50 | $2.50 | $2.50 | $0 (breakeven) |
| $95 | $0.00 | $2.50 | -$250 |
| $100 | $0.00 | $2.50 | -$250 |
| $105 | $0.00 | $2.50 | -$250 |
The breakeven here is $92.50 — the strike minus the premium. Above $95, you lose the full $250 no matter how high the stock goes. Below $92.50, you profit as the stock drops further.
Buying Shares vs. Buying a Call Option
One of the biggest draws of options is leverage. You control 100 shares for a fraction of the cost. But leverage cuts both ways. Here is how buying 100 shares of XYZ at $100 compares to buying 1 call option with a $105 strike for $3.00.
100 Shares vs. 1 Call Contract
| Factor | Buy 100 Shares | Buy 1 Call Option ($105 strike) |
|---|---|---|
| Capital Required | $10,000 | $300 |
| Max Loss | Theoretically $10,000 | $300 |
| Breakeven | $100 | $108 |
| If Stock Hits $115 | +$1,500 (15% return) | +$700 (233% return) |
| If Stock Stays at $100 | $0 (no gain, no loss) | -$300 (100% loss) |
| Time Sensitivity | None (hold indefinitely) | High (contract expires) |
| Dividends | Yes | No |
The percentage returns on the call look incredible when the stock moves in your favor. But look at the "stays at $100" row. The shareholder breaks even. The option buyer loses everything. The stock did not even go down — it just did not go up enough, fast enough. This is the tradeoff that matters.
Risk Considerations
Options are not inherently riskier than stocks — but they are less forgiving of mistakes. Here is what trips up most beginners.
Time decay is relentless. Every day that passes, your option loses a little value. If you buy options with short expirations (under two weeks), time decay accelerates dramatically. You need a fast, significant move just to break even.
Being right is not enough. You can correctly predict that a stock will rise and still lose money if it does not rise enough, or does not rise before expiration. Direction, magnitude, and timing all have to align.
Implied volatility can crush you. Options are more expensive when volatility is high (often before earnings). After the event, volatility drops and option prices collapse — even if the stock moves in your direction. This is called a volatility crush.
Selling options has different risks. This post covers buying options, where your risk is limited to the premium. If you sell options (writing contracts), your risk can be substantial or even unlimited. Do not sell options until you deeply understand the mechanics.
Liquidity matters. Stick to options on well-known, heavily traded stocks. Illiquid options have wide bid-ask spreads that eat into your returns before the trade even starts.
Key Takeaways
Options are contracts that give you the right to buy (call) or sell (put) shares at a set price before a deadline. They offer leverage and defined risk for buyers, but demand that you get direction, magnitude, and timing right. Respect the complexity before putting real money on the line.
- A call profits when the stock rises above the strike plus the premium. A put profits when the stock falls below the strike minus the premium.
- Your maximum loss as an option buyer is always the premium you paid.
- Time decay works against option buyers every day. Longer-dated options give you more room but cost more.
- Options offer leverage — you control 100 shares for a fraction of the price — but that leverage means small mistakes become total losses on the position.
- Start by paper trading options before committing real capital. Learn the mechanics without paying tuition to the market.
Disclaimer: This content is for educational purposes only and does not constitute financial advice. Trading involves substantial risk of loss. Past performance does not guarantee future results.
