A stock option is a contract that gives you the right, but not the obligation, to buy or sell 100 shares of a specific stock at a fixed price before a set expiration date, and it works by charging you an upfront premium in exchange for that right. If the trade would lose money, you let the contract expire and walk away; the premium is all you can lose as a buyer. Options draw their value from the underlying stock rather than representing ownership in the company, which is what lets a small amount of cash control exposure to 100 shares.
The Four Parts of Every Option Contract
Every option is built from four pieces, and the same four appear on every ticker you’ll see quoted:
- The underlying asset: the stock, ETF, or index the option is tied to. One standard equity option contract covers 100 shares.
- The strike price: the fixed price at which you can buy or sell the shares, regardless of where the stock is actually trading.
- The expiration date: the deadline after which the contract no longer exists. After that, the holder has no rights and the seller has no obligations.
- The premium: the upfront price the buyer pays the seller. It is non-refundable and is the maximum a buyer can lose on the trade.
On regulated exchanges, these terms are standardized so any two traders are trading the same contract. The Options Clearing Corporation sits in the middle of every exchange-traded option as buyer to every seller and seller to every buyer, which removes the risk that the person on the other side won’t perform.1OCC. Clearing
Calls and Puts
Options come in two flavors, and every strategy is built from them.
Call Options
A call gives the buyer the right to purchase 100 shares at the strike price before expiration. You buy a call when you expect the stock to rise. Say you buy a call with a $50 strike and pay a $5 premium; the total outlay is $500 for the 100-share contract. If the stock rises to $70 by expiration, your profit per share is $70 minus $50 minus $5, or $15 per share, which comes to $1,500. If the stock stays below $50, you lose the $500 premium and nothing more. Breakeven is $55: the strike plus the premium.
Put Options
A put gives the buyer the right to sell 100 shares at the strike price before expiration. Puts work as a bet that the stock will fall, or as insurance on shares you already own. If you hold 1,000 shares and worry about a near-term drop, buying 10 put contracts locks in a floor sale price for those shares.
Put sellers take the opposite side. When you sell a put, you agree to buy the stock at the strike if the buyer exercises. You collect the premium as income and hope the stock stays above the strike so the contract expires worthless. If the stock falls sharply, you’re still on the hook to buy at the strike no matter how far it has dropped.
How the Premium Is Priced
An option’s premium has two components: intrinsic value and time value. Both matter before you commit money.
Intrinsic value is the tangible portion of the premium. It’s what the option would be worth if you exercised it right now. A call with a $50 strike when the stock trades at $55 has $5 of intrinsic value. If the strike is worse than the current market price, intrinsic value is zero.
Time value is everything above intrinsic value. It reflects the chance the stock could move favorably before expiration. An option with six months to run carries more time value than one expiring next week, because there’s more room for the stock to move. Two calls with identical strikes and the same underlying stock will price differently if one expires in January and the other in June.
Here’s the catch that trips up new buyers: time value decays every day, and the decay accelerates as expiration approaches. An option loses time value slowly when expiration is months away and quickly in the final weeks. At expiration, time value is zero and only intrinsic value remains. Buying options is a race against the clock: the stock has to move enough, fast enough, to overcome both the premium and ongoing decay.
In-the-Money, At-the-Money, and Out-of-the-Money
Three terms describe the relationship between the strike and the current stock price:
- In-the-money (ITM): the option has intrinsic value. A call is ITM when the stock is above the strike; a put is ITM when the stock is below the strike.
- At-the-money (ATM): the strike and stock price are roughly equal. The option has only time value.
- Out-of-the-money (OTM): exercising would produce a loss. A call is OTM when the stock is below the strike; a put is OTM when the stock is above.
Moneyness shifts constantly during the trading day. An option that opens in-the-money can be out-of-the-money by lunch. The classification drives both the price of the option and the probability it ends up worth something. Deep in-the-money options behave much like the stock itself; far out-of-the-money options are cheap but rarely pay off.
What Happens When You Exercise
Most option contracts are never exercised. Traders usually sell the option itself back to the market to capture any remaining time value, since exercising captures only intrinsic value. Exercise typically makes sense at or near expiration, or when a dividend on the underlying stock makes early exercise worthwhile.
When a holder does exercise, they notify their broker, and the OCC randomly assigns the obligation to a seller with a matching short position. On a call exercise, the assigned seller delivers 100 shares at the strike price. On a put, the assigned seller buys 100 shares at the strike. Securities transactions now settle on a T+1 cycle, meaning shares and cash change hands one business day after the trade.2U.S. Securities and Exchange Commission. Shortening the Securities Transaction Settlement Cycle After exercise, the option contract ceases to exist and the former holder owns or has sold actual shares, with all the usual risks and rewards that follow.
American-Style vs. European-Style
Most stock options traded on U.S. exchanges are American-style, which means the holder can exercise at any point before expiration. European-style options can be exercised only at expiration. The names don’t refer to geography; many index options are European-style even though they trade on American exchanges.3FINRA. Trading Options: Understanding Assignment
The distinction matters most to sellers. Sell an American-style call, and a Monday spike could bring assignment before you’ve even thought about the Friday expiration. European-style sellers face assignment only at expiration.
Selling Options and the Risks Involved
Buying an option caps your loss at the premium. Selling is a different exposure. When you write a call or put to open a new position, you take on an obligation the buyer can trigger at any time with American-style contracts.3FINRA. Trading Options: Understanding Assignment
The most dangerous position in options is the naked call: selling a call without owning the underlying shares. A stock can rise indefinitely, so the potential loss has no ceiling. You’d be forced to buy shares at whatever the market demands and deliver them at the strike price. Most brokerages restrict naked call selling to experienced traders with the highest options approval level and substantial margin.
Assignment can also arrive at awkward moments. After-hours moves can expose sellers to assignment they didn’t see coming. Near expiration, when the stock hovers close to the strike, small price swings decide whether you’re assigned or not. That uncertainty, known as pin risk, can leave a seller holding an unwanted stock position over a weekend with no way to hedge until markets reopen.3FINRA. Trading Options: Understanding Assignment
Employee Stock Options Are a Different Animal
The stock options a company grants employees as compensation are not the same instrument as an exchange-traded option, and it’s worth knowing the boundary. Employee options give the worker the right to buy company stock at a fixed price, usually the market price on the grant date. They’re private agreements between employer and employee, they can’t be sold on a market, and they typically carry a vesting schedule before the employee can exercise.
A common vesting arrangement is four years with a one-year cliff: no options vest during the first year, 25% vest all at once on the first anniversary, and the remaining 75% vest gradually, usually monthly, over the following three years.
The tax code splits employee options into two types. Incentive stock options (ISOs) get favorable treatment: no regular income tax at exercise, and if you hold the shares at least one year after exercise and at least two years after the grant date, the whole gain is taxed at long-term capital gains rates.4Office of the Law Revision Counsel. 26 USC 422 – Incentive Stock Options The spread between exercise price and fair market value at exercise can, however, trigger the alternative minimum tax. Nonstatutory stock options (NSOs) work more simply and less favorably: the spread at exercise is taxed as ordinary income, withheld like a paycheck, and any later gain or loss on the shares is a capital gain or loss.5Internal Revenue Service. Topic No. 427, Stock Options
How Options Are Taxed Outside the Employee Context
For exchange-traded options, the tax treatment depends on how long you held the position and what you did with it.
Buy an option and sell it for a profit, and the gain is a capital gain. Hold it for more than a year and it qualifies as long-term, taxed at 0%, 15%, or 20% depending on income. Sell within a year and the gain is short-term, taxed at ordinary income rates, which run as high as 37% for 2026.6Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Most option trades are short-term simply because contracts rarely last that long.
Exercise a call, and the premium you paid rolls into your cost basis for the shares. Pay $5 per share in premium on a $50 strike, and your cost basis for the stock is $55. The holding period for the shares starts the day after exercise, not when you bought the option.5Internal Revenue Service. Topic No. 427, Stock Options
If an option expires worthless, the buyer claims the premium as a capital loss. Sellers who kept the premium without being assigned report it as a short-term capital gain.
Options can also trigger the wash sale rule. Sell stock at a loss and buy a call on the same stock within 30 days before or after, and the IRS disallows the loss. The statute treats a contract or option to buy substantially identical securities the same as buying the stock itself.7Office of the Law Revision Counsel. 26 USC 1091 – Loss From Wash Sales of Stock or Securities The disallowed loss shifts into the cost basis of the replacement position, so it isn’t gone forever, but it can’t offset gains in the current tax year.