What Is an Options Contract?

Introduction

An options contract is a standardized agreement that gives its holder a right, but not an obligation, to buy or sell an underlying asset at a specified price on or before a specified date. The counterparty who sells the option takes on an obligation to fulfill the terms of the contract if the holder exercises that right. These contracts are traded on regulated exchanges and cleared by central clearinghouses, which play a central role in managing performance and counterparty risk.

Options belong to a broader family of instruments known as derivatives. Their value is derived from an underlying asset such as a stock, an exchange traded fund, an index, a futures contract, a currency, or a bond. The contract language is concise, but the economic effects are significant. Options reshape the payoff pattern of an investment by separating the right to transact at a future price from the obligation to do so. That separation is the key to their usefulness in modern markets.

Core Components of an Options Contract

Every listed option specifies a small set of terms that fully define the contract. Understanding these terms is the foundation for understanding how options work.

Underlying Asset

The underlying asset is what the option is written on. In equity markets, the underlying is commonly a publicly traded stock or an exchange traded fund. In index options, the underlying is a published index level. In currency or futures options, the underlying is a foreign exchange rate or a standardized futures contract.

Type: Call or Put

A call option grants the right to buy the underlying at the strike price. A put option grants the right to sell the underlying at the strike price. The right belongs to the holder of the option. The obligation rests with the writer who has sold the option.

Strike Price

The strike price, sometimes called the exercise price, is the fixed price at which the underlying can be bought (for a call) or sold (for a put) if the option is exercised. Strikes are set in standardized increments by the exchange. For index and futures options, strike intervals and listing rules are also standardized.

Expiration Date

The expiration date is the last day the option is valid. After expiration, the contract ceases to exist. Many equity options expire on a Friday designated by the exchange. Index options may expire on a morning settlement timetable. Short term, monthly, and longer dated expirations coexist, providing a calendar of choices.

Exercise Style

American style options can be exercised on any trading day up to and including the expiration date. European style options can only be exercised on the expiration date. Many equity options are American style, while many index options are European style. The exercise style affects early exercise and assignment mechanics, but it does not imply where the option is traded geographically.

Settlement Method

Physically settled options result in delivery of the underlying asset upon exercise. A call exercise leads to purchase of the underlying; a put exercise leads to sale of the underlying. Cash settled options do not deliver an asset. Instead, the holder receives or pays the cash difference between the underlying’s settlement value and the strike. Index options are commonly cash settled.

Contract Size

Equity options in the United States typically have a multiplier of 100 shares per contract, so one contract controls the right on 100 underlying shares. Index and futures options have their own multipliers. Corporate actions such as stock splits or special dividends can lead to contract adjustments to keep economic value consistent. Exchanges and clearinghouses publish adjustment notices when this occurs.

Premium

The premium is the price of the option. The holder pays the premium to acquire the right embedded in the contract. The writer receives the premium and takes on the obligation. Premiums are quoted per unit of the underlying and then scaled by the contract multiplier for total cost. Premium reflects market expectations and the balance of supply and demand.

Rights and Obligations

An option’s defining feature is the asymmetry between the holder and the writer. The holder has the right to choose whether to exercise. The writer accepts the obligation to fulfill the contract if assigned.

For a call option, exercise requires the writer to sell the underlying to the holder at the strike price, subject to settlement rules. For a put option, exercise requires the writer to buy the underlying from the holder at the strike price. Assignment is the process by which the clearinghouse designates which writer must fulfill the obligation. Assignment can occur at any eligible time for American style options and at expiration for European style options.

Because writers assume an obligation that can become costly if the market moves unfavorably, clearinghouses require writers to post collateral or margin. The margin system is designed to reduce counterparty risk and ensure contract performance. Margin requirements vary across products and markets and are published by exchanges and clearinghouses.

Payoffs, Intrinsic Value, and Moneyness

An option’s payoff depends on the relationship between the underlying price and the strike at expiration. Three terms capture that relationship.

• In the money (ITM): A call is ITM if the underlying price is above the strike. A put is ITM if the underlying price is below the strike.
• At the money (ATM): The underlying price is near the strike.
• Out of the money (OTM): A call is OTM if the underlying price is below the strike. A put is OTM if the underlying price is above the strike.

Intrinsic value is the amount an option would be worth if it were exercised immediately. For a call, intrinsic value is max(0, underlying price minus strike). For a put, intrinsic value is max(0, strike minus underlying price). Time value is the portion of the premium above intrinsic value. It reflects the market’s assessment of the possibility that the option’s moneyness could change before expiration. As time passes, time value generally declines, all else equal.

Why Options Exist

Options exist to facilitate the transfer and transformation of risk. They allow market participants to separate price exposure into components. This serves several purposes.

• Risk management: An option can offset particular price risks without eliminating all exposure to the underlying. This supports corporate hedging and portfolio insurance.
• Price discovery: Option prices embed collective expectations about future variability in the underlying. The implied volatility derived from options contributes to the broader process of price formation.
• Contracting flexibility: The right without the obligation is valuable when the future is uncertain. Options enable contingent plans that take effect only under specified conditions.
• Capital efficiency: Options can provide exposure with defined terms and lower upfront cash outlay than purchasing the underlying outright. The tradeoff is the possibility of decay in time value and the obligation borne by writers.

Where Options Fit in the Market Structure

Options trade on organized exchanges with dedicated rulebooks and technology. Quotes are provided by market makers and other participants who post bids and offers. Orders from buyers and sellers meet in a centralized order book that prioritizes price and time. The exchange reports trades, and the clearinghouse becomes the central counterparty to both sides.

The clearinghouse novates each trade, meaning it steps in as the buyer to every seller and the seller to every buyer. This substitution simplifies credit relationships and enables anonymous trading. It also permits netting of positions and systematic handling of exercise and assignment. Daily risk management by the clearinghouse includes margin calls, collateral management, and standardized settlement procedures.

The option market is linked to the underlying market. Price relationships between options and the underlying are maintained through arbitrage and hedging by professional participants. While individual traders may focus on a single contract, the market as a whole functions as part of an integrated price discovery system.

The Life Cycle of an Options Contract Position

A position in an option progresses through identifiable stages.

Initiation

A participant submits an order to buy or sell a specific option series. If the order executes, the holder pays the premium and receives a long position, or the writer collects the premium and receives a short position. The clearinghouse records both positions and calculates margin for the writer.

During the Life of the Contract

After initiation, the option’s market price changes as the underlying price moves, time passes, and expectations about future volatility evolve. Contract adjustments may occur if the underlying undergoes corporate actions. Holders of American style options may exercise early in specific circumstances, such as around certain dividend events for calls, if permitted by market rules. The clearinghouse manages any resulting assignments.

Expiration or Exercise

On the expiration date, in the money options are typically exercised automatically under exchange rules, unless the holder provides contrary instructions. Out of the money options usually expire without value. For European style options, exercise occurs only at expiration. Settlement follows the procedures for the product: physical delivery for equity options, or cash settlement for many index options.

Numerical Examples

Call Option Example

Suppose a stock trades at 50. A call option with a strike of 50 and one month to expiration trades at a premium of 2. The contract controls 100 shares.

If the stock price at expiration is 55, the call is in the money by 5 per share. Exercising the option allows purchase at 50 and sale at the market price of 55, producing an intrinsic gain of 5 per share. The premium of 2 was paid at initiation, so the net result is 3 per share. If the stock finishes at 49, the option expires worthless and the premium paid is the total loss for the holder.

For the writer of this call, the outcomes mirror the holder’s outcomes in the opposite direction. If assigned, the writer sells shares at 50 even if the market price is higher. The premium received partially offsets that obligation.

Put Option Example

Consider a put with a strike of 50 priced at a premium of 1.50 when the stock is at 50. If the stock falls to 45 at expiration, the put is in the money by 5 per share. Exercising the put allows sale at 50 when the market price is 45, generating an intrinsic gain of 5 per share. After deducting the 1.50 premium, the net result is 3.50 per share. If the stock ends at 52, the put expires worthless and the holder’s loss is the premium paid.

For the writer of this put, assignment would require buying shares at 50 even if the market price is lower, with the premium received offsetting a portion of the cost.

Factors That Influence Option Prices

Option premiums are determined in competitive markets. Several core variables influence the price of an option.

• Underlying price relative to strike: Options move toward or away from intrinsic value as the underlying price changes.
• Time to expiration: More time generally means higher premium because there is a greater chance of favorable moves. Time value tends to decline as expiration approaches.
• Expected volatility: Higher expected variability in the underlying’s price increases the option’s value, all else equal, because larger swings raise the chance the option will finish in the money.
• Interest rates: Rates affect the present value of cash flows and the relative attractiveness of deferring payment for the underlying. For calls, higher rates can increase premiums; for puts, higher rates can decrease premiums, holding other inputs constant.
• Dividends or carry costs: Expected dividends reduce call values and increase put values on dividend paying stocks, because dividends lower the stock price on the ex dividend date under standard pricing conventions. For futures, storage or financing costs influence option values through the cost of carry.

Market participants often summarize the market’s expectations of future volatility by quoting implied volatility, which is the volatility input that, when placed into an option pricing model, produces the observed market premium. Although models differ, the core inputs listed above are widely recognized.

Categories of Listed Options

Options appear in multiple product categories, each with its own settlement and exercise conventions.

• Equity options: Written on individual stocks or exchange traded funds, typically American style and physically settled.
• Index options: Written on published index levels, often European style and cash settled.
• Options on futures: Written on standardized futures contracts. Settlement and exercise conventions follow futures market rules.
• Currency options: Written on exchange rates, listed on certain exchanges or traded over the counter with banks and dealers.

Over the counter options are negotiated bilaterally and customized in size, maturity, and terms. They do not enjoy the same degree of standardization and clearing as exchange traded options, so counterparty arrangements differ. The basic economic principles of rights and obligations remain the same.

Risks and Considerations

Options change the distribution of possible outcomes for a portfolio or a corporate balance sheet. That flexibility carries specific risks that are structural to the instruments themselves.

• Obligation risk for writers: Writers must fulfill exercise if assigned. Adverse market moves can make this obligation costly. Clearinghouses mitigate counterparty default risk with margin and collateral policies, but they do not eliminate market exposure for writers.
• Limited life: Options expire. If the expected event does not occur within the option’s life, the contract can lose value through time decay even if the general thesis eventually proves correct.
• Early exercise and assignment: American style options may be exercised before expiration. Writers can be assigned at any eligible time. Early exercise is often tied to dividends for calls or financing considerations for deep in the money contracts.
• Liquidity and transaction costs: Some option series have wider bid ask spreads and lower trading volumes than highly active series. These conditions affect execution quality and realized costs.
• Contract adjustments: Splits, mergers, spinoffs, and special dividends can lead to adjustments in strike, multiplier, or deliverables. Exchanges and clearinghouses publish the official terms that govern these events.

Real World Context

Options are used across the economy to manage uncertainty and align financial exposures with operational needs.

Airline Fuel Exposure

Airlines face volatile jet fuel costs that affect operating budgets. A carrier can purchase call options on a fuel related benchmark or on crude oil to cap the price paid if energy markets spike. The option premium is a known cost that buys the right to purchase at a predetermined level if the market runs higher. If prices remain stable or fall, the option may expire without exercise, and the airline benefits from lower spot prices while having limited the adverse scenario.

Importer Currency Risk

A company that pays suppliers in a foreign currency is exposed to exchange rate fluctuations. A foreign currency call option on the needed currency can protect against depreciation of the domestic currency. If the exchange rate moves unfavorably, the option can be exercised to obtain the foreign currency at the strike. If the exchange rate moves favorably, the firm uses the market rate and allows the option to lapse.

Portfolio Protection

Institutional portfolios may employ index put options to limit downside during periods of market stress. The cost of the options is transparent, and the payoff is linked to the index level at expiration. The contract formalizes a contingent protection that only activates if markets decline beyond a chosen level.

These examples illustrate the core function of options as contracts for risk transfer. The details of execution, sizing, and accounting are governed by internal policies and market rules rather than by the option’s definition alone.

How Options Differ from Other Instruments

Options are distinct from other derivatives and from cash securities.

• Versus the underlying asset: Buying the underlying provides direct ownership and full exposure to price changes. Buying a call option provides conditional exposure that depends on price relative to the strike and time until expiration.
• Versus futures: A futures contract obligates both parties to transact at a future date. An option grants a right to one party and an obligation to the other, with the decision controlled by the holder.
• Versus forwards and swaps: Forwards and swaps are typically obligations with bilateral credit exposure. Exchange traded options are standardized and centrally cleared, which changes how counterparty risk is managed.

Reading an Options Chain

An options chain lists all available contracts for an underlying across strikes and expirations. It is the basic reference for market terms.

• Expiration: Contracts are grouped by date, from near term to longer dated maturities.
• Strike: Within each expiration, strikes are listed in ascending or descending order.
• Bid and ask: The highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
• Last price: The price at which the most recent trade occurred. It may not reflect current executable prices.
• Volume: Contracts traded during the session for that series.
• Open interest: The number of outstanding contracts that remain open at the end of the previous day. It measures existing positions, not current day trading turnover.
• Implied volatility: The volatility figure that aligns a pricing model with the quoted premium. It offers a model based way to compare option richness across strikes and expirations.

By scanning the chain, a reader can identify where trading interest is concentrated and how premiums vary with strike and time. The chain does not predict future prices. It summarizes the current state of the listed contracts.

Regulatory and Standardization Notes

Listed options are governed by exchange rulebooks, regulatory oversight, and clearinghouse procedures. Standardization of contract size, strikes, expirations, and exercise style makes trading and settlement consistent across participants. Clearinghouses publish margin methodologies, manage daily risk, and coordinate exercise and assignment. Settlement cycles and specific processing timelines vary by jurisdiction and product category. Official notices from exchanges and clearinghouses outline operational details when changes occur.

Putting It Together: What an Options Contract Is

An options contract is a legally binding, standardized derivative that defines a potential transaction at a later date on terms set today. It transfers the right to decide from the writer to the holder. It specifies the underlying, strike, expiration, exercise style, settlement method, and size. It trades on an exchange where bids and offers meet, and it is supported by a clearinghouse that manages obligations and counterparty performance.

That structure allows businesses to manage specific risks, investors to tailor exposures, and markets to express and aggregate views about future variability. The contract by itself does not predict outcomes or guarantee results. It provides a clear and enforceable framework within which risks can be transferred and priced.

Key Takeaways

• An options contract grants a right, but not an obligation, to buy or sell an underlying asset at a specified strike price on or before a specified expiration date.
• Calls confer the right to buy and puts confer the right to sell, with the holder possessing the right and the writer holding the obligation subject to exercise and assignment.
• Premium reflects intrinsic value and time value, both influenced by underlying price, time to expiration, expected volatility, interest rates, and dividends or carry costs.
• Exchanges standardize terms and clearinghouses manage counterparty risk, enabling transparent trading and reliable settlement across the market.
• Options exist to transfer and reshape risk, supporting activities such as corporate hedging, portfolio protection, and contingent exposure without obligating immediate transactions.