Options Contract: Definition, Calls vs. Puts, and How They Work
Last updated 05/18/2026 by
Ante Mazalin
Edited by
Andrew Latham
Summary:
An options contract is a financial agreement that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price before or on a set expiration date.
Options are used across several contexts, each with a different risk and reward profile.
- Call option: Gives the holder the right to buy an asset at the strike price, profitable when the market price rises above that level.
- Put option: Gives the holder the right to sell an asset at the strike price, profitable when the market price falls below that level.
- Hedging: Options are widely used by investors and companies to protect existing positions against unfavorable price moves.
- Income generation: Strategies such as covered calls allow investors to collect premium income from options written against shares they already own.
Options add a layer of flexibility to investing that stocks and bonds alone cannot provide. Whether the goal is to protect a portfolio, speculate on a price move, or generate additional income, understanding the structure of an options contract is where it starts.
Key terms in options trading
Every options contract involves four core components that define how and when it pays off.
| Term | Definition |
|---|---|
| Strike price | The fixed price at which the buyer can buy (call) or sell (put) the underlying asset |
| Premium | The price paid by the buyer to acquire the options contract |
| Expiration date | The date by which the option must be exercised or it expires worthless |
| Underlying asset | The security the option is based on, most commonly a stock, index, or ETF |
| In the money (ITM) | An option with intrinsic value: a call where the market price exceeds the strike, or a put where the strike exceeds the market price |
| Out of the money (OTM) | An option with no intrinsic value, only time value remaining before expiration |
How options work: calls and puts
Each standard options contract covers 100 shares of the underlying asset. If you buy one call option on a stock with a strike price of $50 and the stock rises to $70 before expiration, you can exercise the option to buy 100 shares at $50, then sell them at $70, capturing the $20 per share difference minus the premium paid.
If the stock stays below $50, the call expires worthless and you lose only the premium. This defined maximum loss is one of the key features that separates buying options from margin trading, where losses can exceed the initial investment.
Put options work in reverse. If you buy a put with a strike of $50 and the stock falls to $30, you can sell 100 shares at $50 regardless of the lower market price. Investors use puts to hedge against losses on shares they already own, effectively purchasing insurance on a long position.
Pro Tip
The premium you pay reflects both intrinsic value (how far the option is already in the money) and time value (the probability that it will become more profitable before expiration). As expiration approaches, time value erodes through a process called theta decay. Option buyers work against this clock — sellers benefit from it. Buying options with longer expiration dates reduces the drag of theta decay on your position.
Options vs. futures
Options and futures are both derivatives whose value is derived from an underlying asset, but they carry fundamentally different obligations for the buyer.
| Feature | Options | Futures |
|---|---|---|
| Buyer’s obligation | Right but not obligation to exercise | Obligated to fulfill the contract at expiration |
| Maximum loss (buyer) | Limited to the premium paid | Potentially unlimited |
| Upfront cost | Premium paid to the seller | Margin deposit required |
| Common uses | Hedging, income generation, speculation | Hedging commodities and currencies, speculation |
Common options strategies
Options can be combined into strategies that define both the maximum gain and maximum loss before a trade is entered.
- Covered call: Selling a call option against shares you already own to collect premium income. The shares act as collateral, capping the risk of the short call position.
- Protective put: Buying a put option on a stock you own to limit downside risk. Functions like insurance: you pay a premium to cap potential losses on the underlying shares.
- Long straddle: Buying both a call and a put at the same strike price and expiration. Profits if the underlying moves sharply in either direction; loses premium if the price stays flat.
- Iron condor: Selling an out-of-the-money call and put while buying further out-of-the-money options to cap risk. A defined-risk, defined-reward strategy that profits when the underlying trades within a set range.
The Chicago Board Options Exchange (CBOE), which introduced standardized options trading in 1973, publishes educational resources on all major strategies through its Options Institute.
Risks of options trading
The primary risk for option buyers is losing the entire premium paid if the option expires worthless. Sellers face a different and potentially larger risk profile.
- Time decay: Option premiums erode as expiration approaches, working against buyers and in favor of sellers of options.
- Volatility risk: Options prices are directly influenced by implied volatility. A sudden drop in volatility can reduce an option’s value even if the underlying price moves in the expected direction.
- Unlimited risk for uncovered sellers: Selling a call without owning the underlying shares (a naked call) exposes the seller to theoretically unlimited losses if the stock price rises sharply.
- Complexity: Multi-leg strategies involve multiple variables, and misunderstanding a single component can result in significant unintended losses.
Related reading on derivatives and investing
- Short selling — another bearish strategy involving borrowed shares, often compared to buying put options as a way to profit from an anticipated price decline.
- Portfolio — covers how to build and balance a collection of investments, including how options positions can be used to manage overall portfolio risk.
- Dollar-cost averaging — a systematic investing method sometimes combined with options strategies such as selling cash-secured puts to acquire shares at a target price.
Frequently asked questions
What is the difference between a call and a put option?
A call option gives the buyer the right to purchase an asset at the strike price before expiration, typically used when the buyer expects the price to rise. A put option gives the buyer the right to sell at the strike price, typically used when the buyer expects the price to fall or wants to protect an existing position from losses.
How do options make money?
Option buyers profit when the underlying asset moves enough in the expected direction to exceed the cost of the premium paid. Option sellers collect the premium upfront and profit when the option expires worthless or loses value before the buyer exercises it.
What happens when an options contract expires?
If an option expires out of the money, it expires worthless and the buyer loses the premium paid. If it expires in the money, most brokers automatically exercise it, resulting in the purchase or sale of 100 shares of the underlying asset at the strike price unless the account holder instructs otherwise.
Can you lose more than you invest with options?
Option buyers can only lose the premium paid, making the maximum loss defined and limited. Option sellers face greater risk: selling a naked call without owning the underlying shares carries theoretically unlimited loss potential if the stock price rises sharply. Using defined-risk strategies such as spreads limits the maximum loss for sellers as well.
Do you need a special account to trade options?
Yes. Options trading requires broker approval, and most brokers assign traders to approval levels based on experience and financial situation. Buying calls and puts typically requires a standard options approval level. Selling naked options requires the highest approval level and is reserved for experienced, well-capitalized traders who understand the risk involved.
Key takeaways
- An options contract gives the buyer the right, but not the obligation, to buy (call) or sell (put) an asset at a fixed strike price before expiration.
- The premium is the upfront cost of the option; buyers can lose the full premium if the contract expires worthless.
- Options are used for hedging existing positions, generating income through covered calls, and speculating on price direction.
- Time decay (theta) erodes option premiums as expiration approaches, working against buyers and benefiting sellers.
- Sellers of uncovered options can face losses far exceeding the premium collected, making position sizing and risk management critical.
If you are ready to start investing or want to explore platforms that support options trading, compare accounts at SuperMoney’s investment reviews.
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