# How Options Work

> Options give the right, but not the obligation, to buy or sell an asset at a set price by a set date. Learn how options work, why traders use them and the key terms.

Source: https://learn.tradelabsai.com/options/how-options-work/  
Track: Options · Level: Intermediate · Updated: 2026-10-03  
Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice.  
Cite as: TradeLabs Learn, "How Options Work", https://learn.tradelabsai.com/options/how-options-work/

An option is a contract that gives its buyer the right, but not the obligation, to buy or sell an asset at a fixed price on or before a fixed date. The buyer pays a price, called the premium, for that right. The seller receives the premium and takes on the obligation to complete the trade if the buyer chooses to use the option. This lesson walks through how the pieces fit together; the short overview is in [What Is an Option?](https://learn.tradelabsai.com/markets/what-is-an-option/), and a full route through the topic is in the [Options Learning Path](https://learn.tradelabsai.com/start-here/options-learning-path/).

## The parts of an option

| Term | Meaning | Lesson |
|---|---|---|
| Underlying | The asset the option is on, such as a stock, index, future or currency | |
| Call | The right to buy the underlying | [Calls and Puts](https://learn.tradelabsai.com/options/calls-and-puts/) |
| Put | The right to sell the underlying | [Calls and Puts](https://learn.tradelabsai.com/options/calls-and-puts/) |
| Strike price | The price at which the underlying can be bought or sold | [Strike Price](https://learn.tradelabsai.com/options/strike-price/) |
| Expiration | The last date the option can be used | [Option Expiration Dates](https://learn.tradelabsai.com/options/option-expiration-dates/) |
| Premium | The price paid for the option | [Option Premium](https://learn.tradelabsai.com/options/option-premium/) |
| Contract size | How many units one contract covers; 100 shares for US stock options | |

## A simple example

**Example: Buying a call option**
A stock trades at $50. You buy one call option with a $55 strike that expires in two months, paying a premium of $2.00 per share. Because one contract covers 100 shares, the total cost is $200.

- If the stock rises to $62 at expiration, you can buy 100 shares at $55 and they are worth $62: $700 of value, minus the $200 premium, for a $500 profit.
- If the stock stays below $55, the option expires worthless and you lose the $200 premium, no more.

Buying the shares outright would have cost $5,000. The option offered exposure to the rise for $200, with a known maximum loss.

## Buyers and sellers

Every option has two sides:

| | Buyer (holder, long) | Seller (writer, short) |
|---|---|---|
| Pays or receives premium | Pays | Receives |
| Rights or obligations | Has the right to exercise | Must fulfil if assigned |
| Maximum loss | The premium paid | Can be large, with no upper limit for short calls |
| Maximum gain | Can be large | The premium received |

Selling options earns premium income but carries obligations and potentially large losses. See [Short Call](https://learn.tradelabsai.com/options/short-call/) and [Short Put](https://learn.tradelabsai.com/options/short-put/).

## What determines an option's price

An option's premium depends mainly on:

1. **The underlying price relative to the strike.** See [Moneyness: ITM, ATM and OTM](https://learn.tradelabsai.com/options/moneyness-itm-atm-and-otm/).
2. **Time to expiration:** more time means more chance of a favourable move.
3. **Volatility:** bigger expected moves make options more valuable. See [Implied Volatility (IV)](https://learn.tradelabsai.com/volatility/implied-volatility/).
4. **Interest rates and dividends,** which have smaller effects.

The premium splits into intrinsic value, what the option would be worth if used now, and extrinsic value, the extra paid for time and uncertainty. See [Intrinsic and Extrinsic Value](https://learn.tradelabsai.com/options/intrinsic-and-extrinsic-value/).

## How options end

An option can end in three ways:

- **Sold or bought back** before expiration. Most option positions are closed this way.
- **Exercised:** the holder uses the right to buy or sell the underlying. See [Exercise and Assignment](https://learn.tradelabsai.com/options/exercise-and-assignment/).
- **Expire worthless** if it has no intrinsic value at expiration.

## Why traders use options

- **Leverage:** control a large position with a smaller outlay.
- **Defined risk:** buyers know their maximum loss up front.
- **Hedging:** protect a portfolio against falls. See [Protective Put](https://learn.tradelabsai.com/options/protective-put/).
- **Income:** sell options to collect premium. See [Covered Call](https://learn.tradelabsai.com/options/covered-call/).
- **Trading volatility:** profit from the size of moves rather than direction. See [Volatility Trading](https://learn.tradelabsai.com/volatility/volatility-trading/).
- **Building custom payoffs** with combinations. See [Option Payoff Diagrams](https://learn.tradelabsai.com/options/option-payoff-diagrams/).

## The risks

- **Time decay:** options lose value as expiration approaches, all else equal. See [Theta](https://learn.tradelabsai.com/options/theta/).
- **Total loss for buyers** when options expire worthless.
- **Large losses for sellers,** especially of uncovered calls.
- **Complexity:** prices respond to several factors at once. See [The Option Greeks Explained](https://learn.tradelabsai.com/options/the-option-greeks-explained/).
- **Liquidity:** less active options have wide bid ask spreads.

## Where options trade

In the United States, listed stock and index options trade on exchanges such as Cboe and Nasdaq and are cleared by the Options Clearing Corporation, which guarantees each contract. Options also trade on futures, currencies and crypto on various exchanges. To trade options, brokers usually require approval for different strategy levels.

## Frequently asked questions

### How do options work in simple terms?

An option is a contract that lets you buy (call) or sell (put) an asset at a set price before a set date. You pay a premium for that right.

### Can you lose more than you invest with options?

Option buyers can lose at most the premium paid. Option sellers can lose much more, and uncovered call sellers face losses with no upper limit.

### Why are options contracts for 100 shares?

US stock options are standardised so that one contract covers 100 shares, which is why a quoted premium of $2.00 costs $200 per contract.

Next, learn the two basic types in [Calls and Puts](https://learn.tradelabsai.com/options/calls-and-puts/).

## Sources

- Options Industry Council, [Options education](https://www.optionseducation.org/)
- Wikipedia, [Option (finance)](https://en.wikipedia.org/wiki/Option_%28finance%29)

## Continue learning

- Next lesson: [Calls and Puts](https://learn.tradelabsai.com/options/calls-and-puts/)
- Related: [What Is an Option?](https://learn.tradelabsai.com/markets/what-is-an-option/): An option is the right, not the obligation, to buy or sell at a set price before a set date. Learn calls, puts, premiums, strikes and how options gain or lose value.
- Related: [Calls and Puts](https://learn.tradelabsai.com/options/calls-and-puts/): A call gives the right to buy and a put gives the right to sell at a set price. Learn how calls and puts work, how they profit and how buyers and sellers differ.
- Related: [Strike Price](https://learn.tradelabsai.com/options/strike-price/): The strike price is the fixed price at which an option can be exercised. Learn how strikes affect cost, probability and payoff, and how traders choose them.
- Related: [Option Premium](https://learn.tradelabsai.com/options/option-premium/): The option premium is the price paid for an option. Learn what drives it, including price, strike, time, volatility, rates and dividends, with worked examples.
- Related: [Option Expiration Dates](https://learn.tradelabsai.com/options/option-expiration-dates/): Every option has an expiration date when it must be used or expire. Learn monthly, weekly and 0DTE cycles, what happens at expiry and how to choose an expiration.
- Related: [Options Learning Path](https://learn.tradelabsai.com/start-here/options-learning-path/): An ordered route through options: calls and puts, pricing, basic positions, the Greeks, spreads and volatility, with practice tasks at every stage.