Quick answer

An option is a contract between two parties. The buyer pays a price, called the premium, for the right to buy or sell a specific asset at a fixed price on or before a set date. The seller collects that premium and takes on the matching obligation.

There are two basic types. A call is the right to buy; a put is the right to sell. A standard equity option covers 100 shares of the underlying stock.

The key word is right, not obligation. The buyer can walk away and lose only the premium paid; the seller cannot.

A closer look

Every listed option is defined by four terms: the underlying stock, whether it is a call or a put, the strike price, and the expiration date. Together these pin down exactly what can be exchanged, at what price, and until when.

A worked example. A stock trades at $100. A call option with a $105 strike expiring in 30 days is quoted at $2.40 per share. Because one contract covers 100 shares, the buyer pays $240 and the seller collects $240.

• If the stock finishes at $110, the right to buy at $105 is worth $5 per share, so the contract is worth $500 against the $240 paid.
• If the stock finishes at $105 or below, the right to buy at $105 has no value and the contract expires worthless. The buyer's loss is the $240 premium; the seller keeps it.

Notice the asymmetry. The buyer's maximum loss is fixed at the premium, while the outcome for the seller depends entirely on where the stock goes. That asymmetry is why an option's price reflects probabilities as much as direction; the market is pricing a whole range of possible outcomes, a concept covered under probability and the expected move.

Options rarely need to be held to the end. They trade on exchanges throughout the day, so a position opened for $240 can usually be closed at the going market price at any point before expiration.

The formal detail

Formally, a listed equity option is a standardized derivative cleared through a central clearing house, which stands behind performance on both sides once a trade is matched. Standardization covers the contract multiplier (normally 100), strike intervals, and expiration cycles, which is what makes listed options fungible and tradable, unlike private bilateral contracts.

Style matters. American-style options, which include listed equity options, can be exercised on any trading day up to expiration. European-style options, typical of index options, can be exercised only at expiration. The mechanics are covered under exercise and assignment.

A common misconception is that an option's price moves one-for-one with the stock. It does not; the sensitivity depends on delta, and changes in implied volatility or the simple passage of time can move the premium even when the stock is unchanged.