An option contract is an agreement between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or sell a specific asset at a specific strike price on or before a specific expiration date. Options sellers are obligated to buy or sell shares of the underlying security per the options contract’s terms.
The buyer is referred to as the "holder," and the seller is referred to as the "writer." Options buyers are said to be "long" the options contract, while options sellers are "short" the options contract. Options can be bought and sold on a variety of underlying assets, including stocks, bonds, indexes, and futures.
There are four components to every options contract:
- The underlying asset
- The strike price
- The expiration date
- The cost (also known as the premium)
Options contracts are derivative investments because their value is derived from the contract’s underlying asset.
For example, a Microsoft options contract derives its value from the price movement of Microsoft stock.
Options have a contract multiplier. Because option contracts are leveraged financial instruments, one stock option contract is equivalent to 100 shares of the underlying asset.
The strike price is the specific price at which the underlying security can be bought or sold with an options contract.
The expiration date is the last trading day that an option can be exercised.
Every option contract has an associated cost, or premium. The premium is the price the buyer pays and the seller receives. Option premiums are based on multiple factors, including the time until expiration, volatility, and the underlying's price relative to the strike price.
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