What is an Option?

An option is a contract between two parties (buyer and seller). The buyer pays a premium for the right to either buy/sell (depending on the option type) an underlying stock at a specific price (strike price) within a fixed period of time (options have an expiration date). The seller collects the premium for taking on the risk associated with having to buy/sell the underlying stock at that specific price (strike price), if the buyer decides exercise their option (depends on moneyness of the option).

Participants in the options market buy and sell call and put options. Buyers of options are called holders. Sellers of options are called writers. Option holders are said to have long positions, and writers are said to have short positions.

 

Specifications of Option Contracts

Option Types

There are two types of stock option contracts (call and put). The buyer of a call option has the right to buy an underlying stock at a strike price within a fixed period of time. The buyer of a put option has the right to sell an underlying stock at a strike price within a fixed period of time.

Underlying Asset

Each contract specifies the stock that needs to be bought/sold by the seller of the option in the occurrence that the buyer decides to exercise their option. Each contract covers 100 shares of the underlying stock.

Premium

This is the price for the option that is paid by the buyer and collected by the seller. This premium is based off of strike price, moneyness, time value, implied volatility, and intrinsic value.

Strike Price

This is the agreed upon price that the underlying stock will be bought or sold if the option is exercised by the buyer. The strike price determines the option’s moneyness (ITM, ATM or OTM) and heavily affects the price of the option (premium).

Moneyness

There are three states of moneyness for an option: (ITM) In-the-money, (ATM) At-the-money, and (OTM) Out-of-the-money. ITM means the option is likely to be exercised by the buyer, while ATM and OTM the buyer may exercise their option, but is less likely due to the option still having extrinsic value.

Expiration Date

Every option eventually expires. If the option is ITM, the buyer of the option has the right to exercise up until the expiration date. After the expiration date, the option is worthless and can no longer be exercised by the holder of the option.

Contract Multiplier

In the case that a stock option is exercised. Each stock option covers 100 shares.

Option Style

There are two types of option styles (American style or European style). The manner in which options can be exercised also depends on the style of the option. American style options can be exercised any time before expiration while European style options can only be exercise on expiration date itself. All of the stock options currently traded in the marketplaces are American-style options.