Options basics: calls, puts and payoff at expiry

An option is a contract that gives its buyer the right, but not the obligation, to trade an asset at a set price before a set date. The set price is the strike. The date is the expiration. The price you pay for the contract is the premium.

Calls and puts

• A call gives the right to buy at the strike. Buyers hope the price rises.
• A put gives the right to sell at the strike. Buyers hope the price falls.

The seller, also called the writer, takes the other side. The seller collects the premium and must perform if the buyer exercises.

A worked example

You buy one call with a $100 strike for a premium of $3.50 per share. One US equity option contract covers 100 shares, so you pay $350.

• If the stock is at $95 at expiry, the call is worthless and you lose the $350.
• If the stock is at $103.50, you break even: the $3.50 of value in the option exactly offsets what you paid.
• If the stock is at $110, the option is worth $10 per share, or $1,000. After the $350 cost, you profit $650.

For a buyer, the most you can lose is the premium. For a seller of an uncovered call, the loss can be very large, because the stock price has no upper limit.

What changes the price before expiry

Besides the stock price, an option's value depends on time left, which decays, and on implied volatility, the market's estimate of how much the price may move. A trade can lose money even when the stock moves your way if time decay or a fall in volatility outweighs the move.

Common pitfalls

• Options expire. A correct idea that takes too long can still lose.
• Leverage cuts both ways: a small move in the stock can mean a large percentage change in the option.
• Early assignment can happen to sellers.
• Spreads can be wide on less active contracts.

Use the options payoff calculator to chart a single call or put. Brokers require approval and a risk disclosure document before you can trade options; read it first.