Investing Basics · definition
Options Contract
An option is a contract giving the right, but not the obligation, to buy (call) or sell (put) an asset at a fixed price before a set date. Buyers pay a premium for that right.
An options contract gives its buyer the right, but not the obligation, to buy or sell an underlying asset at a fixed price (the strike) on or before a set date (the expiry). A call is the right to buy; a put is the right to sell. The buyer pays a premium for this right; the seller (writer) receives the premium and takes on the matching obligation.
Key takeaways
- Calls give the right to buy, puts the right to sell, both at the strike price.
- The buyer's maximum loss is the premium paid; an uncovered seller's potential loss can be far larger.
- An option's value combines intrinsic value (how far it is "in the money") and time value.
- Regulators classify options as complex products; brokers must screen customers before granting options access.
How the mechanics work
One standard U.S. equity option covers 100 shares. Suppose a stock trades at $50 and a call with a $55 strike expiring in three months costs a $2 premium. If the stock rises to $60, the right to buy at $55 is worth $5 of intrinsic value. If the stock stays below $55, the option expires worthless and the buyer loses the $2. The same arithmetic in mirror image applies to puts.
What options are used for
Descriptively, options serve three roles in markets. Hedging: a put can act as insurance on an existing holding. Income: writers collect premiums in exchange for accepting obligations. Speculation: options offer leveraged exposure, large percentage gains and losses on small stakes. The same contract can be conservative or aggressive depending on how it is combined with other positions, which is why broker questionnaires distinguish covered from uncovered strategies.
Documented risks
Options expire; being right about direction but wrong about timing still loses money. Uncovered writing carries open-ended risk. Pricing involves volatility, time decay and interest rates (formalised in the Black-Scholes model, Nobel Memorial Prize 1997), making behaviour less intuitive than shares. Regulators publish standardised risk disclosures that every options customer must receive. This entry describes the instrument; it does not suggest using it.
Frequently asked questions
What does "in the money" mean?
A call is in the money when the asset price is above the strike; a put when it is below. Out-of-the-money options have no intrinsic value, only time value.
Do options pay dividends?
No. Option holders do not own the underlying shares and receive no dividends or voting rights unless they exercise.
Sources
This entry is for education only. Investing Value describes how financial concepts work; it does not provide investment, tax or legal advice, and nothing here is a recommendation to buy or sell any asset.