Stock Options Explained: Basics of Options Trading

Key Takeaways

• Stock options are contracts that give the right, but not the obligation, to buy or sell 100 shares of an underlying stock at a set price before a set date.
• Calls give the right to buy, puts give the right to sell; buyers pay a premium and have limited loss, sellers collect the premium but can face larger risk.
• Strike price, expiration date, and premium determine an option's value; intrinsic and extrinsic value explain how that price breaks down.
• Common beginner strategies include buying calls or puts, selling covered calls, and selling cash-secured puts; each has different risk profiles.
• Options can be useful for hedging and leverage, but they carry unique risks such as time decay, assignment, and rapid loss of value.

Introduction

Stock options are financial contracts that let you control shares of a stock for a limited time without buying the shares outright. They can be used to speculate, hedge an existing position, or generate income, but they also introduce new risks you need to understand.

Why should you care about options if you're new to investing? Options offer leverage that can amplify returns and losses. They also let you create strategies that aren't possible with shares alone. What will you learn here, and how will it help you? This guide breaks down the basics, shows practical examples with real tickers, and explains common beginner strategies and pitfalls.

How Options Contracts Work

An option is a contract tied to an underlying stock. Each standard equity option typically represents 100 shares. So one option contract gives you the right to buy or sell 100 shares of the underlying security at a specified price called the strike price, until the contract expires on the expiration date.

Key terms defined

• Underlying: the stock the option is based on, for example $AAPL or $TSLA.
• Call option: gives the buyer the right to buy the underlying at the strike price.
• Put option: gives the buyer the right to sell the underlying at the strike price.
• Strike price: the fixed price at which the option can be exercised.
• Expiration date: the last day the option can be exercised or traded.
• Premium: the price you pay to buy the option contract, quoted on a per-share basis, then multiplied by 100 for the contract.
• Intrinsic value: how much the option is in-the-money, if any.
• Extrinsic value: the premium beyond intrinsic value, often driven by time and volatility.

Example: Suppose $AAPL is trading at $150 per share. A call with a $155 strike expiring in one month might trade for $1.50. That premium means one contract costs $150 because $1.50 times 100 shares equals $150.

Calls and Puts: What Buyers and Sellers Face

Calls and puts create different payoffs for buyers and sellers. Buyers pay the premium and have limited downside to that premium. Sellers receive the premium but take on obligations that can be costly.

Buying a Call

When you buy a call, you expect the underlying stock to rise above the strike price plus the premium before expiration. Your maximum loss is the premium you paid. Your upside is potentially unlimited while the stock can rise.

Example: You buy one $AAPL 160 call expiring in 30 days for a $2.00 premium while $AAPL trades at $155. Your cost is $200. Break-even at expiration is $162. If $AAPL rises to $170, the option is worth $10 intrinsic, or $1,000, and your profit before fees is $800.

Buying a Put

Buying a put is a bearish bet. You profit if the underlying falls below the strike less the premium. Again, your loss is limited to the premium you paid.

Example: You buy one $TSLA 600 put expiring in 45 days for a $12 premium with $TSLA at $620. Your cost is $1,200. Break-even at expiration is $588. If $TSLA falls to $540, the put is worth $60 or $6,000, producing a $4,800 gain before fees.

Selling Options: Obligations and Risk

Selling (writing) an option obligates you to buy or sell the underlying if the buyer exercises. Sellers keep the premium but can face large losses if the market moves against them.

Common beginner-seller strategies are covered calls and cash-secured puts, which limit risk compared with naked selling but still expose you to stock risk or assignment.

Why Option Prices Move

Option prices are driven by the underlying stock price, time until expiration, implied volatility, interest rates, and dividends. The two main components of an option's price are intrinsic and extrinsic value.

Intrinsic vs Extrinsic Value

• Intrinsic value is the amount an option is in-the-money. For a call, intrinsic = max(0, stock price - strike).
• Extrinsic value, or time value, reflects remaining time and volatility. It decays to zero at expiration.

Time decay, called theta, accelerates as expiration approaches. High implied volatility raises premiums because the market expects larger price swings, increasing the chance the option moves in-the-money.

Practical Examples and Numbers

Concrete examples make the math clear. Remember each contract controls 100 shares and multiply quoted premiums by 100 to get the contract cost.

Example 1: Buying a Call on $AAPL

1. $AAPL current price: $150
2. Buy one 155 call, premium $2.50 per share
3. Cost: $2.50 times 100 equals $250
4. Break-even: strike plus premium equals $157.50
5. If $AAPL at expiration = $165, option intrinsic = $10 per share, value = $1,000, profit = $750 before fees

Example 2: Selling a Covered Call on $MSFT

You own 100 shares of $MSFT at $320. You sell one 330 call for $3.00, collecting $300. If $MSFT stays below 330 by expiration you keep the premium. If it rises above 330 you may be assigned and sell 100 shares at 330, giving up further upside beyond that strike but keeping the premium.

Example 3: Buying a Put to Hedge $AMZN

Suppose you own 100 shares of $AMZN at $125. You buy one 110 put for $1.50 per share to limit downside. Cost is $150. If $AMZN falls below 110 your losses on the stock are offset starting at 110 less the premium paid. This is a basic hedge against a sharp drop.

Common Beginner Strategies

Here are simple strategies you can study and understand before risking capital. Each strategy has trade-offs between cost, risk, and complexity.

• Long calls and long puts — limited loss to premium, straightforward directional bets.
• Covered calls — own the stock and sell calls to generate income, caps upside beyond strike.
• Cash-secured puts — sell puts while keeping enough cash to buy the stock if assigned, yields premium income and may result in acquiring stock at an effective discount.
• Bull and bear spreads — buying and selling options with different strikes to limit cost and risk, but also limit maximum gain.

Risks Specific to Options

Options add layers of complexity and risk beyond owning shares. Time decay, assignment risk, liquidity, and leverage can create rapid losses if you aren't careful.

• Time decay (theta): Options lose extrinsic value as expiration approaches, especially short-dated options.
• Assignment risk: Option sellers can be assigned at any time for American-style options, forcing share delivery or purchase.
• Leverage risk: Small moves in the underlying can translate to large percentage changes in option value.
• Liquidity and spreads: Wide bid-ask spreads increase trading costs and slippage.

Common Mistakes to Avoid

• Choosing the wrong expiration: Picking very short expirations to save premium often traps buyers as time decay accelerates. Avoid unless you understand theta and implied volatility.
• Ignoring contract size: Remember one option usually equals 100 shares. Not accounting for this can lead to oversized positions. Calculate dollar exposure before trading.
• Overleveraging: Using options to take oversized bets can magnify losses. Limit position size to a small percentage of your portfolio until you're experienced.
• Not considering assignment: Sellers sometimes forget they can be assigned early, leading to unexpected stock positions. Keep enough cash or share availability to handle assignment.
• Trading illiquid options: Low-volume strikes can have wide bid-ask spreads and unpredictable fills. Favor liquid contracts on major tickers like $SPY or $AAPL while learning.

FAQ

Q: What does it mean if an option is "in the money"?

A: An option is in the money when exercise would be profitable based on the current stock price. For a call, in the money means stock price is above the strike. For a put, it means stock price is below the strike.

Q: How much money can I lose when buying options?

A: When you buy options, your maximum loss is the premium you paid plus fees. Buyers do not have further obligations beyond the premium cost.

Q: Can options be exercised early?

A: Yes, American-style options can be exercised any time before expiration. European-style options can only be exercised at expiration. Most U.S. equity options are American-style.

Q: Do I need a special account to trade options?

A: Yes, brokers require approval for options trading and assign an approval level based on your experience and financial situation. Levels control which strategies you can use, for example buying options only versus selling uncovered options.

Bottom Line

Stock options give you flexible ways to express views about the market, hedge existing positions, and generate income. They come with unique vocabulary like strike price, premium, intrinsic value, and expiration, and each concept determines the risk and reward of every trade.

If you're new, start slowly. Paper trade or use small positions, learn how premiums change with time and volatility, and practice calculating break-evens and potential outcomes. At the end of the day, options can be powerful tools when you understand their mechanics and respect their risks.

Next steps: open an options approval request with your broker, study a few liquid tickers such as $AAPL and $SPY, and simulate trades to see how premiums and Greeks behave before trading with real capital.