What Are Stock Options? Options in the Stock Market Explained

Search Fintrev

Search our guides, reviews and glossary.

A stock option is a contract that gives its holder the right, but not the obligation, to buy or sell 100 shares of a specific stock at a fixed price (the strike price) on or before a set expiration date. The buyer pays a premium for that right. The seller, called the writer, collects the premium and takes on the obligation to buy or sell the shares if the holder exercises. Stock options are also called equity options. The term covers two different things: listed options that trade on exchanges, and employee stock options that companies grant as compensation.

What Is a Stock Option?

Options are derivatives: their value is derived from something else, the underlying asset. For a stock option, the underlying is shares of one company’s stock. Options on a stock index use the index as the underlying instead, and options on exchange-traded funds use ETF shares. All of these sit in the broader family of options, which also includes options on futures, currencies and commodities.

There are two basic types:

• Call option: the holder may buy the underlying shares at the strike price. Calls gain value when the stock rises above the strike.
• Put option: the holder may sell the underlying shares at the strike price. Puts gain value when the stock falls below the strike.

Each option has two sides. The holder (long position) owns the right and decides whether to use it. The writer (short position) has no choice: if the holder exercises, the writer must deliver or accept the shares at the strike price. This asymmetry drives most of the risk differences between buying and selling options.

Listed stock options in the United States trade on exchanges such as Cboe, PHLX and ISE, and they are cleared through the Options Clearing Corporation, which stands between buyers and sellers so that neither side depends on the other’s creditworthiness. Not every stock has listed options. An exchange has to list an option series on a stock before anyone can trade it.

Employee stock options (ESOs) work differently. A company grants them directly to its own employees, they cannot be sold to other people, and their terms are set by the company’s plan rather than by an exchange. They are covered in their own section below.

How Stock Options Work

An option fixes a price today for a trade that may happen later. The holder pays the premium upfront. From then until expiration, the holder can do one of three things: sell the option to someone else, exercise it, or let it expire.

Most listed options positions are closed by selling (or buying back) the option rather than by exercising it. Selling the contract captures both its intrinsic value and any remaining time value, while exercising captures only the intrinsic value and gives up the rest.

Moneyness: in, at or out of the money

Moneyness describes where the stock price sits relative to the strike:

Suppose stock XYZ trades at $100. A $90 call is in the money because the holder could buy at $90 shares worth $100. A $110 call is out of the money: nobody would pay $110 for shares available at $100. For puts the logic flips: a $110 put is in the money, and a $90 put is out of the money.

Intrinsic value and time value

An option’s premium has two components:

Option premium = intrinsic value + time value (extrinsic value)

Intrinsic value is what the option would be worth if exercised right now:

• Call intrinsic value = max(0, stock price − strike price)
• Put intrinsic value = max(0, strike price − stock price)

Time value is everything above intrinsic value. It reflects the chance that the option becomes more valuable before expiration. An out-of-the-money option has no intrinsic value, so its whole premium is time value. It still has a price because the stock could move past the strike before the contract expires.

Using XYZ at $100: if the $90 call trades at $12, its intrinsic value is $10 and its time value is $2. If the $110 call trades at $1.50, all $1.50 is time value.

Time value falls toward zero as expiration approaches, a process called time decay. At expiration an option is worth only its intrinsic value, which for an out-of-the-money option is nothing.

What moves an option’s price

Six inputs feed into option prices: the stock price, the strike price, time to expiration, the volatility of the underlying, interest rates and expected dividends. Volatility deserves special attention. The more a stock is expected to move, the higher the chance an option ends up deep in the money, so higher expected volatility raises the premiums of both calls and puts on that stock.

Pricing models such as the Black-Scholes model combine these inputs into a theoretical value. The sensitivity of an option’s price to each input is measured by the option Greeks: delta for the stock price, theta for time, vega for volatility and gamma for the rate at which delta changes.

Leverage

Because an option costs a fraction of the shares it controls, a given move in the stock produces a much larger percentage move in the option. That leverage works in both directions. A stock can rise a little and leave a call buyer with a total loss if the rise is not large enough or does not happen before expiration.

Key Parameters of Stock Options

Every listed option is defined by a handful of standardized terms. Together they identify a specific contract in an option chain, for example “XYZ June 105 call.”

American vs. European style

• American-style options can be exercised on any business day up to and including expiration. Listed options on individual U.S. stocks are American style.
• European-style options can be exercised only at expiration. Many index options use this style.

The style concerns exercise, not geography. Both styles can be bought or sold in the market at any time before expiration.

Expiration date

The expiration date is the last day the option exists. Standard monthly U.S. equity options expire on the third Friday of the month, and exchanges list them according to expiration cycles. Many stocks also have weekly expirations, and some have long-dated options called LEAPS (Long-Term Equity AnticiPation Securities) that run for more than a year. Other things being equal, more time to expiration means more time value and a higher premium, because the stock has longer to make a favorable move.

Strike price

The strike price, or exercise price, is the price at which the shares change hands if the option is exercised. It determines moneyness and intrinsic value. Exchanges list a range of strikes around the current stock price, so a trader can choose between a cheaper out-of-the-money option that needs a large move and a costlier in-the-money option that needs a smaller one.

Contract size

One standard stock option contract represents 100 shares of the underlying stock. Buying five call contracts gives the right to buy 500 shares. If a company splits its stock, pays a special dividend or is involved in a merger, the contract terms may be adjusted so that the option holder is not unfairly helped or hurt, which can leave a contract covering a non-standard number of shares or a different deliverable.

Premium

Premiums are quoted per share. The total cost of a position is:

Total premium = quoted price × 100 × number of contracts

Five contracts quoted at $1.00 cost $500 ($1.00 × 100 × 5), plus any commissions and fees. The buyer pays the premium in full upfront. The writer receives it and, depending on the position, may have to post margin with the broker.

Worked Examples

The figures below are hypothetical and chosen to show the mechanics. They ignore commissions, fees and taxes, and they assume the positions are held to expiration.

Buying a call

XYZ trades at $100. A trader expects a rise and buys one XYZ $105 call expiring in two months at $3.00.

• Cost: $3.00 × 100 = $300
• Break-even at expiration: strike + premium = $105 + $3 = $108
• Maximum loss: the $300 premium

Outcomes at expiration:

Compare that with buying 100 shares for $10,000. At $115 the shareholder gains $1,500, or 15%. The call buyer gains $700 on $300, about 233%. At $100 the shareholder breaks even while the call buyer loses everything. Note the middle row: at $106 the call is in the money and worth $100, yet the position still loses money because the stock did not clear the break-even price.

Buying a put

Same stock at $100. A trader expects a decline and buys one XYZ $95 put at $2.50.

• Cost: $250
• Break-even at expiration: strike − premium = $95 − $2.50 = $92.50
• Maximum loss: the $250 premium
• Maximum gain: if XYZ fell to zero, the put would be worth $95 × 100 = $9,500, for a profit of $9,250

If XYZ ends at $85, the put is worth $10 × 100 = $1,000, a $750 profit. If XYZ ends anywhere above $95, the put expires worthless. Puts are covered in more depth in what a put option is.

Writing a put

A trader who is bullish, or who would be happy to own XYZ at a lower price, can sell the $95 put instead of buying a call. The writer receives $250.

• If XYZ stays above $95 through expiration, the put expires worthless and the writer keeps the $250.
• If XYZ ends at $85, the writer is assigned and must buy 100 shares at $95 ($9,500) that are worth $8,500. The $1,000 loss on the shares, less the $250 premium, leaves a net loss of $750.
• If XYZ went to zero, the loss would be $9,500 − $250 = $9,250.

The writer’s gain is capped at the premium, while the potential loss is much larger. Writing calls without owning the stock (naked calls) is riskier still, because a stock’s price has no upper limit and neither does the writer’s loss.

Using a put as a hedge

An investor owns 100 shares of XYZ at $100 and buys one $95 put at $2.50 for protection. If XYZ falls to $70, the shares lose $3,000, but the put is worth $2,500, so the combined loss is $500 plus the $250 premium, $750 in total. No matter how far XYZ falls before expiration, the investor can sell the shares at $95. The $250 premium is the cost of that floor, and it is lost entirely if the stock holds up.

Common Ways Stock Options Are Used

Options let a trader express a view on direction, timing and volatility, or reshape the risk of an existing stock position.

• Speculation: buying calls or puts to profit from a price move with a defined, limited outlay.
• Hedging: buying puts against shares already owned, as in the example above, or against a portfolio of similar stocks.
• Income: writing covered calls on shares the investor owns. The investor collects premium in exchange for agreeing to sell the shares at the strike if the stock rises above it, which caps the upside.
• Entering a position at a target price: writing cash-secured puts, setting aside enough cash to buy the shares if assigned.

Spreads combine long and short options on the same stock, often with different strikes or expiration dates. A bull call spread, for instance, buys one call and sells a higher-strike call. The premium collected on the short call lowers the cost, and in exchange the maximum profit is capped at the difference between the strikes minus the net premium paid. Spreads define risk on both sides, which is why traders use them to limit losses compared with outright short options.

Volatility trades do not depend on direction. A straddle buys a call and a put at the same strike and expiration, profiting if the stock moves far enough in either direction to cover both premiums.

When choosing among contracts, traders look at trading activity in each series. Volume shows how many contracts traded during a session, and open interest shows how many contracts remain open. Series with little activity can have wide bid-ask spreads, which raises the cost of getting in and out.

Exercise and Assignment

Exercising a call means buying 100 shares per contract at the strike price. Exercising a put means selling 100 shares per contract at the strike price. Once exercised, the option no longer exists and the share trade settles in its place.

The writer on the other side receives an assignment. Because U.S. stock options are American style, a short option holder can be assigned at any time the option is in the money, not just at expiration. Early assignment on short calls is most likely just before a stock goes ex-dividend, since a call holder may exercise to collect the dividend.

At expiration, the Options Clearing Corporation automatically exercises options that are in the money by $0.01 or more unless the holder instructs the broker otherwise. A trader who holds an in-the-money call without the cash or margin to buy the shares can end up with a position the account cannot support, which is a common reason to close options before the final day.

Exercising early usually gives up time value. If the $90 call from the earlier example trades at $12 with the stock at $100, exercising captures $10 of intrinsic value, while selling the contract collects $12.

Stocks vs. Options

The last row is the core difference. A shareholder who is right about the direction eventually profits, however long it takes. An option buyer needs the move to arrive before expiration and to be large enough to exceed the premium.

Employee Stock Options (ESOs)

Employee stock options are call options a company grants to its own employees, directors or contractors as compensation. They give the right to buy company stock at a fixed exercise price for a limited time. Companies use them to reward performance or tenure and to tie employees’ pay to the company’s share price. Unlike listed options, ESOs cannot be traded, and their terms are set in the grant agreement and the company’s plan.

Vesting and cliffs

ESOs typically cannot be exercised as soon as they are granted. They vest over a schedule, and only vested options can be exercised unless the plan allows early exercise.

A hypothetical example: an employee at a startup receives options on 12,000 shares that vest over four years with a one-year cliff. Nothing vests during the first year. At the one-year mark, 3,000 options vest at once (the cliff). The rest vest in further installments until all 12,000 have vested at the end of year four. If the employee leaves before the cliff, nothing has vested.

Grants also carry an expiration date. The overall term can run for years, but many plans shorten the window to exercise vested options after the employee leaves the company, sometimes to a matter of months. The exact dates are in the grant documents.

Valuing employee stock options

For a publicly traded company, the intrinsic value of ESOs follows the same formula as listed calls:

ESO intrinsic value = (current share price − exercise price) × number of vested options

Hypothetically, options on 20,000 shares with a $2 exercise price have no intrinsic value while the stock trades at $1. If the stock rises to $3, they are worth ($3 − $2) × 20,000 = $20,000 before taxes.

For a private company there is no market price. The most recent valuation of the company’s shares gives a starting point, but it is an estimate, and private shares may be hard or impossible to sell until a sale of the company or a public listing. The number of shares outstanding matters too: the more shares and options a company has issued, the smaller the slice of the company each share represents.

When employees exercise, the company usually issues new shares, which increases the share count. This dilution affects existing shareholders, which is why investors look at how many options a company has granted and how many remain outstanding.

Ways to exercise employee options

Exercising means paying the exercise price for each share. An employee exercising options on 12,000 shares at $1 must pay $12,000, regardless of the current market price. The shares then belong to the employee, subject to any plan restrictions, insider trading rules or transfer limits on private-company stock.

For employees without the cash, many plans at public companies offer two broker-assisted methods:

• Exercise-and-sell (cashless exercise): the broker exercises the options and sells all the resulting shares at once, using the proceeds to cover the exercise price, and the employee receives the remaining cash.
• Exercise-and-sell-to-cover: the broker sells only enough shares to cover the exercise price (and often the tax withholding), and the employee keeps the rest of the shares.

Tax Treatment of Stock Options in the U.S.

The rules below apply to U.S. federal income tax. Other countries treat employee options and listed options differently, and individual circumstances vary, so this is a description of the framework rather than tax advice.

For employee options, the key figure is the bargain element: the difference between the market value of the shares at exercise and the exercise price paid. Exercising options on 10,000 shares at $1 when the stock trades at $2 creates a $10,000 bargain element. How and when that amount is taxed depends on whether the option is statutory or non-statutory.

Statutory stock options

Statutory options are incentive stock options (ISOs) and options granted under an employee stock purchase plan (ESPP). Neither the grant nor the exercise is generally taxed as regular income. However, exercising ISOs can trigger the alternative minimum tax (AMT), because the bargain element counts as income for AMT purposes.

Tax falls due when the shares are sold. If the employee holds ISO shares for more than two years after the grant date and more than one year after the exercise date, the sale is a qualifying disposition and the whole gain over the exercise price is taxed as a long-term capital gain. Selling earlier is a disqualifying disposition: part of the gain is taxed as ordinary income, which the employer reports on the employee’s Form W-2, and any remainder is a capital gain.

Non-statutory stock options

Non-statutory options (NSOs, also called non-qualified stock options) are options granted outside an ISO or ESPP plan. Their treatment depends on whether the option itself has a readily determinable fair market value.

• If the option is actively traded on an established market, its value can be determined and it is taxed as ordinary income when granted. No further income is recognized at exercise.
• Most NSOs do not have a readily determinable value. In that case there is no tax at grant. At exercise, the bargain element is taxed as ordinary income at the employee’s regular rate.

After exercise, any further change in the share price is a capital gain or loss when the shares are sold. Shares held for one year or less produce a short-term gain, taxed at ordinary income rates. Shares held for more than one year produce a long-term gain, generally taxed at 0%, 15% or 20% depending on income, with some exceptions.

Listed options bought and sold in a brokerage account follow the capital gains rules: a gain or loss on closing or expiration, short term or long term depending on how long the option was held. When an option is exercised, its premium is folded into the cost basis or sale proceeds of the shares rather than taxed separately.

Types of Stock Option Plans

Companies structure option grants in different ways, each with its own balance of risk and incentive.

Limitations and Risks of Stock Options

• Time works against buyers. Time value decays every day, and the decay tends to speed up near expiration. A correct view that arrives too late still loses money.
• Total loss is a normal outcome. An option that expires out of the money is worthless, and the buyer loses the full premium.
• Leverage magnifies losses. The same feature that produces large percentage gains produces large percentage losses, and it encourages position sizes that look small in dollars but carry large exposure.
• Writers carry large or unlimited risk. A short put can lose nearly the full strike value, and a naked short call has no theoretical limit on losses. Brokers require margin for short options and can raise it or close positions when the market moves.
• Volatility can change the price on its own. An option can lose value even when the stock moves in the expected direction if expected volatility drops, as often happens after a scheduled event such as an earnings release has passed.
• Trading costs. Bid-ask spreads and per-contract commissions take a larger share of a small premium than of a stock trade, and they apply on both entry and exit.
• Availability and complexity. Not every stock has listed options, and U.S. brokers approve customers for options trading at different levels, with higher levels required for strategies such as writing uncovered options.
• ESO-specific risks. Employee options can lose all their value if the share price falls below the exercise price, private shares may be impossible to sell for years, exercising can require cash plus tax before any sale, and leaving the company can start a short countdown to exercise or forfeit vested options.

Paper trading in a stock market simulator lets a beginner see how premiums, break-even prices and time decay behave before committing money, although simulated fills do not reflect real liquidity.

FAQs

The Bottom Line

Stock options matter to traders who want leverage or protection and to employees paid partly in company stock. Buyers risk only the premium but need the right direction, a large enough move and good timing, while writers can lose far more than they collect. Employees should read their grant documents for vesting, exercise windows and tax treatment before deciding when to exercise or sell.