Options Basics: How Calls and Puts Work, With Simple Examples

Key takeaways

• An option is a contract giving the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at a set price before or on a set date.
• One standard US stock option contract generally covers 100 shares, so a quoted premium is multiplied by 100.
• Option buyers can lose the entire premium they pay. Option sellers collect the premium but take on an obligation that can lead to large losses.
• An option's price depends on the stock price relative to the strike, the time left until expiration and the expected volatility.
• You need broker approval to trade options, and you should read the standard options risk disclosure first.

Options let traders bet on a stock's direction, protect an existing position or generate income, often with less money up front than buying shares. That leverage works both ways, and many options expire worthless. This guide covers the basic building blocks: what calls and puts are, how they are priced and how a simple trade can play out. All prices are hypothetical examples. Once the basics are clear, multi-leg strategies such as the one in Jade Lizard Options Strategy: How It Works become much easier to follow.

Calls and puts

• A call option gives the buyer the right to buy the underlying stock at the strike price until the option expires. Call buyers generally expect the stock to rise.
• A put option gives the buyer the right to sell the underlying stock at the strike price until the option expires. Put buyers generally expect the stock to fall, or want protection against a fall in shares they own.

Every option has two sides. The buyer (holder) pays a premium and gets the right. The seller (writer) receives the premium and takes on the obligation: to sell shares at the strike if a call is exercised, or to buy shares at the strike if a put is exercised.

Key terms

• Underlying: the stock or other asset the option is based on.
• Strike price: the price at which the option can be exercised.
• Expiration date: the last day the option exists. After that, it has no value.
• Premium: the price of the option, paid by the buyer to the seller. It is quoted per share, so a hypothetical $2.00 premium means $200 for one 100-share contract.
• Exercise: using the right to buy or sell at the strike. Assignment is when a seller is required to fulfil the obligation.
• American and European style: American-style options can be exercised at any time before expiration; European-style options only at expiration. Most US stock options are American style.

In, at and out of the money

These terms describe where the stock price is compared with the strike.

	Call option	Put option
In the money	Stock price above the strike	Stock price below the strike
At the money	Stock price at or near the strike	Stock price at or near the strike
Out of the money	Stock price below the strike	Stock price above the strike

An in-the-money option has intrinsic value: the amount it would be worth if exercised immediately. The rest of the premium is time value, which reflects the chance the option becomes more valuable before expiring. Out-of-the-money options are made up entirely of time value.

Hypothetical example: a stock trades at $73. A $70 call is $3 in the money, so it has $3 of intrinsic value. If its premium is $4.50, the other $1.50 is time value.

What moves an option's price

• Stock price versus strike. Calls gain value as the stock rises; puts gain value as it falls.
• Time to expiration. More time means more chance for a favourable move, so longer-dated options cost more. Time value shrinks as expiration approaches, a process called time decay, and tends to speed up near the end.
• Volatility. The more the market expects a stock to move, the higher the premium. Expected volatility built into option prices is called implied volatility; Understanding Volatility explains it in more detail.

Implied volatility often rises ahead of earnings and falls sharply after the report. An option buyer can be right about the direction and still lose money if the move is smaller than the market expected. What to Watch Before Earnings covers the implied move.

Buying a call: a worked example

Hypothetical example: a stock trades at $68. A trader buys one $70 call expiring in about a month for a premium of $2.20, paying $220.

• Breakeven at expiration: strike plus premium, $70 + $2.20 = $72.20.
• If the stock is at $76 at expiration: the call is worth $6 ($600). Profit is $600 − $220 = $380.
• If the stock is at $71: the call is worth $1 ($100), a loss of $120.
• If the stock is at or below $70: the call expires worthless, and the full $220 is lost.

Buying 100 shares at $68 would cost $6,800. The call controls the same number of shares for $220, which is why options are described as leveraged. But the shareholder still owns the stock if it ends at $70; the call buyer has lost everything paid.

Buying a put: a worked example

Hypothetical example: a stock trades at $72. A trader buys one $70 put for $2.20, paying $220. The breakeven at expiration is $70 − $2.20 = $67.80. If the stock falls to $64, the put is worth $6 ($600), a $380 profit. If the stock stays above $70, the put expires worthless.

A shareholder can buy puts as insurance. The put limits the loss on the shares below the strike for the life of the option, in exchange for the premium.

The seller's side

Selling options collects premium up front, and the seller keeps it if the option expires worthless. The risks are different:

• A seller of an uncovered (naked) call faces losses with no theoretical limit if the stock rises sharply.
• A put seller can be required to buy the stock at the strike even if it has fallen far below.
• Selling a call against shares you already own, a covered call, generates income but caps your upside at the strike.

Brokers usually require higher approval levels and margin for selling options.

Closing, exercising and expiration

Most option traders never exercise. They close positions before expiration by selling an option they bought, or buying back an option they sold. In-the-money options may be exercised automatically at expiration, so know your broker's rules and close or roll positions in time if you do not want to buy or sell the shares.

Options can have wide bid-ask spreads, especially on less active contracts, so limit orders are commonly used.

Getting started safely

• Get approval from your broker and read the options risk disclosure document, Characteristics and Risks of Standardized Options.
• Start with defined-risk trades, such as buying a call or put, where the most you can lose is the premium.
• Risk only a small part of your account on any option trade, as covered in Risk Management Basics for Traders.
• Track each trade, including the premium, the implied volatility and the result.

Common questions

Do I have to own the stock to buy a call or put?

No. You can buy calls or puts without owning the underlying shares. Selling a covered call does require owning the shares.

What happens if I do nothing at expiration?

Out-of-the-money options generally expire worthless. In-the-money options may be exercised automatically, which could leave you buying or selling 100 shares per contract. Check your broker's policy.

Sources

• Investor.gov: An Introduction to Options (Investor Bulletin)
• Investor.gov: Options
• Investopedia: Call Option
• Investopedia: Put Option
• Investopedia: Strike Price
• Investopedia: In the Money
• Investopedia: Time Value
• Investopedia: Intrinsic Value

This article is for general information only and is not financial advice. All prices are hypothetical examples and ignore commissions and fees. Options involve risk and are not suitable for all investors.