What Is an Option Contract?
An option contract is a standardized legal agreement traded on regulated exchanges that gives one party (the buyer) the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a predetermined price within a specified time frame. The other party (the seller or writer) takes on the obligation to fulfill the contract if the buyer decides to exercise. Option contracts are available on stocks, ETFs, indexes, commodities, and currencies.
Standardization is what makes exchange-traded option contracts different from privately negotiated (over-the-counter) options. Every element of a listed option contract is specified by the exchange: the underlying asset, contract size (100 shares for equity options), available strike prices, expiration dates, and settlement procedures. This standardization enables efficient trading and ensures that all market participants understand exactly what they are buying or selling.
One standard equity option contract controls 100 shares. A premium of $3.00 per share means the total contract cost is $3.00 × 100 = $300. Five contracts control 500 shares and cost $1,500 in premium.
Components of an Option Contract
| Component | Description | Standard Value |
|---|---|---|
| Underlying Asset | The stock, ETF, or index the contract is based on | Any optionable security |
| Contract Size | Number of shares per contract | 100 shares (standard equity) |
| Strike Price | The exercise price for buying or selling shares | Set at standardized intervals |
| Expiration Date | The last day the contract is valid | Third Friday of expiration month (monthly) |
| Option Type | Call (right to buy) or Put (right to sell) | Call or Put |
| Exercise Style | When the contract can be exercised | American (any time) or European (at expiry) |
| Settlement | How the contract is fulfilled | Physical delivery (shares) or cash settled |
How Option Contracts Are Priced
Option contracts are priced using mathematical models, primarily the Black-Scholes model for European-style options and binomial models for American-style options. These models take into account the current stock price, strike price, time to expiration, risk-free interest rate, expected dividends, and implied volatility to calculate a theoretical fair value for the contract.
Option Contract Leverage Example
- 1Total shares controlled = 5 × 100 = 500 shares
- 2Total premium cost = $3.00 × 500 = $1,500
- 3Notional value of shares = $100 × 500 = $50,000
- 4Leverage ratio = $50,000 / $1,500 = 33:1
- 5If stock rises to $115: Contracts worth ($115-$105) × 500 = $5,000
- 6Profit = $5,000 - $1,500 = $3,500 (233% return)
- 7Same $1,500 in stock would buy 15 shares: profit = $15 × 15 = $225 (15% return)
Option Contract Expiration Cycles
Option contracts are available in several expiration cycles. Monthly options expire on the third Friday of each month and are the most widely traded. Weekly options (weeklies) expire every Friday and are popular for short-term trades around events like earnings. Quarterly options expire on the last business day of each quarter. LEAPS (Long-Term Equity Anticipation Securities) are long-dated options with expirations up to three years away, used for longer-term directional bets and hedges.
Exercise and Assignment
When an option buyer decides to use their right, they exercise the contract. The option seller is then assigned, meaning they must fulfill the obligation. For call assignment, the seller must sell shares at the strike price. For put assignment, the seller must buy shares at the strike price. Assignment can happen at any time for American-style options, though it most commonly occurs at or near expiration or just before an ex-dividend date.
Contract Adjustments
Option contracts can be adjusted due to corporate actions such as stock splits, reverse splits, special dividends, mergers, and spinoffs. When a 2-for-1 stock split occurs, each existing contract is adjusted to cover 200 shares at half the original strike price, maintaining the same economic value. Adjusted options can have non-standard terms (such as deliverables of 150 shares or shares plus cash), so traders should verify contract specifications before trading.
Adjusted option contracts (resulting from corporate actions) may have non-standard deliverables. Always check the OCC's contract adjustment notices before trading adjusted options to understand exactly what you are buying or selling.