Options basics: calls, puts, and premiums

Options are where a lot of people's eyes start to glaze over, mostly because of the vocabulary. The underlying idea, though, is something you've probably already done in real life.

Think about putting a deposit down on a house. You pay the seller a small, non-refundable amount to hold the house at an agreed price for, say, 60 days. If you go through with the purchase, great — you pay the rest at that agreed price. If you walk away, you simply lose the deposit. You were never obligated to buy; you paid for the right to.

That's almost exactly what an option is.

The basic vocabulary

Call option — the right to buy something at a set price, by a set date.
Put option — the right to sell something at a set price, by a set date.
Strike price — the price you've locked in (like the house price in the deposit example).
Premium — what you pay upfront for the option (like the deposit).
Expiration — the date by which you have to use the option, or it becomes worthless.

Notice the word "right" doing a lot of work there. That's the whole point of an option — it gives you a choice, not a commitment.

A worked example

Say a stock is trading at $50. You think it might go up, so you buy a call option with a strike price of $55, expiring in one month, for a premium of $2 per share.

If the stock rises to $65, you can exercise your right to buy at $55 — instantly worth $10 per share, against the $2 you paid.
If the stock stays at $50, or falls, there's no reason to buy at $55 when the market price is lower. You simply let the option expire. Your loss is capped at the $2 premium you paid — nothing more.

That capped downside is one of the most important features of buying an option: you can never lose more than the premium you paid, no matter how badly wrong you are.

The other side of the trade

Someone has to be on the other side of that contract — the person who sold (or "wrote") the call option, and collected your $2 premium. Their risk profile is the mirror image of yours:

If the stock stays below $55, the option expires worthless, and they simply keep your $2. Nice, easy income.
If the stock shoots up to $100, they're obligated to sell you shares at $55 — a large loss, in theory unlimited, since a stock price has no ceiling.

This asymmetry — capped risk for the buyer, potentially large risk for the seller — is the single most important thing to understand before going anywhere near real options trading. It's covered in more depth in the upcoming lesson on covered calls.

Calls and puts, side by side

	Call option	Put option
Gives the buyer the right to...	Buy the underlying	Sell the underlying
Buyer typically expects	Price to rise	Price to fall
Buyer's maximum loss	The premium paid	The premium paid
Buyer's maximum gain	Theoretically unlimited	Large, but capped (price can't go below zero)

Quick recap

An option is the right, not the obligation, to buy (call) or sell (put) something at a set price by a set date.
You pay a premium upfront for that right — the most you can ever lose as a buyer.
The seller of the option takes on the opposite, uncapped side of that risk in exchange for collecting the premium.