What Is a Call Option and a Put Option? Options Explained for Beginners

A call option is a contract giving its owner the right to buy a stock at a fixed price, and a put option gives its owner the right to sell at a fixed price. Neither one forces the owner to do anything. The person on the other side of the trade carries the obligation.

This page covers what an option contract is, how calls and puts differ, the four terms that define every contract, and why beginners misread premium quotes by a factor of 100. The worked examples use invented round numbers. It is descriptive throughout.

What an option contract is

An option is an agreement between two parties about a possible future transaction in another asset. The buyer pays money now and receives a right, not an obligation. The seller takes the money and accepts the matching obligation.

The buyer can walk away and lose only what was paid. The seller cannot, and the cost of that obligation depends on how far the share price moves. Listed contracts with the same underlying, strike and date are interchangeable.

What a call option is

A call is the right to buy the underlying at the strike price, up to the expiration date. Hypothetical example: a stock trades at 40 dollars and you buy one call struck at 45, expiring in three months, quoted at 2.00. The quote is per share and one contract covers 100 shares, so you pay 200 dollars.

• Finish at 50: the right to buy at 45 is worth 500 dollars. Less the 200 paid, the position ends 300 dollars ahead.
• Break-even is 47, the strike plus the premium, a move of 17.5 percent from 40.
• Finish at 46: the right is worth 100 dollars, a 100 dollar loss, even though the price finished above the strike.
• Finish at or below 45: the contract expires worthless and the 200 dollars is gone, which is the buyer's worst case.

What a put option is

A put is the right to sell the underlying at the strike price, on the same terms. Same stock at 40 dollars: you buy one put struck at 35 expiring in three months, quoted at 1.50, so 150 dollars.

• Finish at 30: the right to sell at 35 is worth 500 dollars, so the position ends 350 dollars ahead of the 150 paid.
• Break-even is 33.50, the strike minus the premium. Finish at 34 and the position ends 50 dollars behind.
• Finish at or above 35: the contract expires worthless, because shares can be sold in the open market at no worse than the strike.

A share price cannot fall below zero, so a 35 strike put is worth at most 35 a share.

The four things that define every contract

• Underlying. The asset the contract is written on. This page describes US listed options on a single stock or an ETF, which are exercisable any trading day up to expiration and settle in shares. Index options such as those on the S&P 500 work differently: they are exercisable only at expiration and settle in cash.
• Strike price. The fixed price at which the right to buy (call) or sell (put) applies.
• Expiration date. The date the right ends; after it the contract no longer exists.
• Premium. The price paid for the contract, quoted per share.

The premium trips up most beginners. A standard US equity option covers 100 shares, so a quote of 2.00 costs 200 dollars before fees and a quote of 0.35 costs 35 dollars.

The number of contracts still open at each strike and date is published as open interest.

Intrinsic value and time value

The premium splits into two parts. Intrinsic value is what the contract would be worth if it expired now: for a call, the share price minus the strike; for a put, the strike minus the share price; either one floored at zero. Both example contracts above have zero intrinsic value.

Time value is the rest. That 45 strike call cost 2.00 with no intrinsic value, so the whole premium paid for the chance the share price travels far enough before the date runs out. It grows with the time left and with the range of moves the market is pricing, an input called implied volatility, which differs strike by strike and forms options skew.

Time value shrinks as expiry approaches and reaches zero on the date, which is why a contract can lose money with the share price unchanged. Kresmion publishes a free options implied probability tool which reads an option chain and shows the probability the market is pricing for a given strike.

What happens at expiry

Exercise: the owner uses the right, buying 100 shares per contract at the strike (call) or selling 100 (put). US listed options finishing at least 0.01 in the money are usually exercised automatically unless the owner instructs otherwise. Automatic exercise of that 45 strike call means paying 4,500 dollars for 100 shares, so an owner who does not want the shares closes the contract before expiry.

Assignment: the obligation lands on a seller picked by the clearing house. An assigned call seller delivers 100 shares at the strike; an assigned put seller buys them, and the cash has to be there.

Expiring worthless: the contract ends with no intrinsic value and the premium stays with the seller. Many positions reach none of the three: the owner sells the contract back into the market before expiry and keeps the difference.

The premium collected at the start is the most a seller's position can earn, and the obligation runs while it stays open, usually against posted margin. The dealers and market makers who take the other side in size hedge in the underlying shares, and that hedging can feed back into the stock, which dealer gamma exposure measures.

Key takeaways

Frequently asked questions

What is the difference between a call option and a put option?

A call is the right to buy the underlying at the strike price; a put is the right to sell it at that price. Both are bought from a seller who accepts the matching obligation, and both expire on a fixed date.

How much does one option contract cost?

Multiply the quoted premium by 100 for a standard US equity option, then add fees. A quote of 1.25 is 125 dollars for one contract, because quotes are shown per share.

Can you lose more than you paid for an option?

Not as a buyer. The most an option buyer can lose is the premium paid, which happens whenever the contract expires with no intrinsic value. A seller is in a different position, because meeting the obligation can cost far more than the premium.

Do you have to exercise an option to make money on it?

No. Most positions are closed by selling the contract back into the market before expiry, settling the difference between the purchase and sale prices in cash. A contract with time value left in it is usually worth more sold than exercised.

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Source: standard listed options contract terms from the US options exchanges and the Options Clearing Corporation. This page is information, not investment advice. Kresmion Research.