What Is an Options Contract? Types and How It Works

Search Fintrev

Search our guides, reviews and glossary.

An options contract is a standardized or privately negotiated agreement that gives its buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a fixed price (the strike price) on or before a set expiration date. The buyer pays a premium for that right. The seller, called the writer, collects the premium and takes on the obligation to complete the trade if the buyer chooses to exercise.

What Is an Options Contract?

An options contract is a type of derivative: its value comes from something else, the underlying asset. Underlyings include individual stocks, exchange-traded funds, stock indexes, interest rates, commodities, futures contracts and currencies. Currency options, for example, give the right to buy or sell one currency against another at a set exchange rate, and they trade both on exchanges and over the counter between banks and institutional clients.

Every options contract specifies the same core components:

• Underlying asset: what the contract gives the right to buy or sell.
• Option type: call (right to buy) or put (right to sell).
• Strike price: the price at which the underlying changes hands if the option is exercised.
• Expiration date: the last day the right exists. After it, the contract no longer exists.
• Contract size (multiplier): how many units of the underlying one contract covers, typically 100 shares for US equity options.
• Exercise style: when the buyer may exercise (American or European, explained below).
• Settlement method: physical delivery of the underlying, or a cash payment equal to the option’s value at exercise.
• Premium: the price the buyer pays the writer. It is not part of the standardized terms; it is set by the market and changes constantly.

On a listed exchange, everything except the premium is fixed by the exchange, so contracts with the same underlying, type, strike and expiration are interchangeable. That standardization is what makes it possible to close a position by trading the same contract in the opposite direction instead of waiting for expiration. Over-the-counter options can be customized on any of these terms, at the cost of that interchangeability and with direct exposure to the other party’s ability to pay.

How an Options Contract Works

Buyers, writers and the premium

Every options contract has two sides. The holder (buyer) pays the premium upfront and acquires the right; the writer (seller) receives it and accepts the obligation. If assigned, a call writer must deliver the underlying at the strike price, and a put writer must buy it at the strike price.

Premiums are quoted per unit of the underlying, not per contract. A stock option quoted at $2.00 with a 100-share multiplier costs $200 per contract, before commissions and fees. The cash cost of an option position is therefore:

Cash cost = premium quote × contract multiplier × number of contracts + commissions and fees

Buying 5 contracts quoted at $1.40 with a 100-share multiplier costs $1.40 × 100 × 5 = $700, plus whatever the broker charges.

Opening and closing positions

Because listed options are standardized, a position does not have to end in exercise. Brokers use four order labels that describe what a trade does to your position:

A holder who sells to close collects the current premium, which includes any remaining time value that exercising early would forfeit; this is how most holders who profit exit. A writer who buys to close pays the current premium and is released from the obligation.

Exercise, assignment and settlement

When a holder exercises, the exchange’s clearinghouse assigns the obligation to a writer of that same contract. In the US, the Options Clearing Corporation stands between buyers and sellers of listed options, which removes the need to trust the specific counterparty. The assigned writer then delivers or receives the underlying (physical settlement) or pays the difference in cash (cash settlement, common for index options).

For US exchange-listed equity options, contracts that finish in the money by at least $0.01 at expiration are generally exercised automatically unless the holder instructs otherwise. A holder of an in-the-money option who lacks the cash or shares to complete the resulting trade can end up with a position the account cannot support, which is one reason many holders close before expiration.

American vs. European exercise

The exercise style determines when the holder may use the right:

• American-style options can be exercised on any trading day up to and including expiration. Most US options on individual stocks and ETFs are American-style.
• European-style options can be exercised only at expiration. Many index options and many over-the-counter currency options are European-style.

The labels describe exercise rules, not where the contract trades. A European-style option can still be bought and sold on any trading day before expiration; only exercise is restricted.

Contract size: how many shares are in an option contract

One standard US equity option contract covers 100 shares, so 1,000 contracts correspond to 100,000 shares of exposure at exercise. A trader who bought 10 contracts holds 10 options, or exposure to 1,000 shares; the contract is simply the unit in which options trade.

The multiplier is not fixed forever. After a stock split, a special dividend, a merger or a spin-off, the exchange can adjust existing contracts so holders and writers are neither helped nor harmed by the corporate action. A 2-for-1 split, for instance, typically doubles the number of contracts and halves the strike. Uneven events can produce nonstandard contracts that deliver, say, 150 shares or a basket of shares and cash. Before trading an adjusted contract, read its deliverable, because the quote alone will not tell you what exercise produces.

Standard listed contracts are not generally offered on fewer than 100 shares, though some exchanges list mini or reduced-size products on certain underlyings. Other asset classes use different multipliers: futures options deliver one futures contract, and currency options specify a notional amount of the base currency.

Call and Put Options

A call option gains value as the underlying rises above the strike price. A put option gains value as the underlying falls below the strike price. Each can be bought or sold, which produces four basic positions with different payoffs:

A short call is called covered when the writer owns the shares that would be delivered; the share position offsets losses from the call. An uncovered (naked) short call has no such offset, which is why its loss has no ceiling. A short put is described as cash-secured when the writer holds enough cash to buy the shares at the strike if assigned.

Payoff at expiration

At expiration, an option’s value equals its intrinsic value. Per unit of the underlying, with S as the underlying price at expiration and K as the strike:

• Call value at expiration = max(S − K, 0)
• Put value at expiration = max(K − S, 0)

Subtracting the premium gives the holder’s profit or loss per unit. Multiply by the contract size for the dollar result. The break-even points follow directly:

• Long call break-even = strike + premium
• Long put break-even = strike − premium

These formulas ignore commissions and fees, and they describe the position only at expiration. Before expiration, the option also carries time value, so its market price is usually higher than these formulas suggest.

How an Options Contract Is Priced

Moneyness

Moneyness describes the relationship between the strike and the current underlying price:

• In the money (ITM): exercising now would have positive value. A call is ITM when the underlying is above the strike; a put is ITM when the underlying is below the strike.
• At the money (ATM): the underlying is at or very near the strike.
• Out of the money (OTM): exercising now would have no value. A call is OTM when the underlying is below the strike; a put is OTM when the underlying is above it.

Intrinsic value and time value

Premium = intrinsic value + time value

Intrinsic value is what the option would be worth if exercised immediately (zero for OTM options). Time value is everything else: the price of the possibility that the option becomes more valuable before it expires. An OTM option’s entire premium is time value.

Time value shrinks as expiration approaches, a process called time decay. This is why options are described as wasting assets: if the underlying does not move, a holder loses value each day and a writer gains it.

The inputs that move the premium

Six inputs drive an option’s price:

1. Underlying price: a rise helps calls and hurts puts; a fall does the reverse.
2. Strike price: lower strikes make calls more expensive; higher strikes make puts more expensive.
3. Time to expiration: more time generally means more time value for both calls and puts.
4. Implied volatility: the market’s expectation of how much the underlying will move. Higher implied volatility raises the premium of both calls and puts, because larger moves make a payoff more likely.
5. Interest rates: higher rates tend to raise call values and lower put values, all else equal.
6. Dividends: expected dividends lower the value of calls and raise the value of puts on the stock, because the share price drops by about the dividend amount when the stock goes ex-dividend.

Pricing models combine these inputs into a theoretical value. The best known is the Black-Scholes model, covered in detail in how the Black-Scholes model prices options. The sensitivity of the premium to each input is measured by the Greeks (delta for price, theta for time, vega for volatility, gamma for how delta changes), explained in option Greeks: delta, gamma, theta and vega.

Volatility can work against buyers. An option bought when implied volatility is high can lose value after the expected event passes even if the underlying moves in the buyer’s favor, because the premium falls as implied volatility drops.

Example of an Options Contract

The following examples are hypothetical and ignore commissions, fees and taxes. Each uses a 100-share contract.

Buying a call vs. buying the stock

Stock ABC trades at $100. You expect it to rise within a month. Two choices:

1. Buy 100 shares at $100: cost $10,000.
2. Buy one call with a $100 strike expiring in one month, at a premium of $2.00: cost $2.00 × 100 = $200.

One month later, at expiration, ABC is at $120.

• Shares: ($120 − $100) × 100 = $2,000 profit on $10,000, a 20% return.
• Call: value at expiration = max($120 − $100, 0) = $20 per share, or $2,000 per contract. Profit = $2,000 − $200 = $1,800 on $200, a 900% return.

Now suppose the same $10,000 had gone into calls instead: $10,000 ÷ $200 = 50 contracts. At expiration each is worth $2,000, so the position is worth $100,000, and the profit is $100,000 − $10,000 = $90,000.

The leverage cuts the other way as well. If ABC finished at $100 or below, the 50 contracts would expire worthless and the entire $10,000 would be lost, while the shareholder would still own stock worth roughly what they paid. If ABC finished at $101, the call holder with one contract would recover $100 of the $200 premium and still lose money, because the break-even is $102 (strike plus premium).

Hedging with a put

You own 100 shares of XYZ at $50 and worry about a decline over the next three months. You buy one put with a $48 strike for $1.50 ($150 total).

• If XYZ falls to $40 at expiration, the shares lose $1,000. The put is worth max($48 − $40, 0) = $8, or $800. Net loss: $1,000 − $800 + $150 = $350. Without the put, the loss would have been $1,000.
• If XYZ rises to $58, the put expires worthless. The shares gain $800, and the net gain is $800 − $150 = $650.

The combination of shares plus a put is called a protective put. It caps the downside below the strike, and the premium is the cost of that coverage, paid whether or not it is needed.

Writing a covered call

You own 100 shares of DEF at $60 and sell one call with a $65 strike expiring in one month for $1.00, collecting $100.

• If DEF stays below $65 at expiration, the call expires worthless. You keep the $100 and the shares, and you can write another call.
• If DEF rises to $72, you are assigned and must sell the shares at $65. Your gain is ($65 − $60) × 100 + $100 = $600. The holder of the call captures everything above $65.

A covered call trades away upside above the strike in exchange for income. It does not protect against declines beyond the premium collected: if DEF falls to $50, the shares lose $1,000 and the premium offsets only $100.

How Options Contracts Are Used

Hedging

Hedging means taking a position that gains when an existing exposure loses. A portfolio manager holding stocks can buy puts on those stocks or on an index that tracks them; if prices fall, the puts gain value and offset part of the loss. A company expecting to receive euros in six months can buy a currency option that sets a minimum conversion rate while keeping the benefit if the exchange rate moves in its favor. That flexibility is what separates an option hedge from a forward or futures hedge, which locks in a rate in both directions.

Speculation

Because an option controls 100 shares for a fraction of their price, it amplifies percentage returns, as the call example shows. A long put lets a trader profit from a decline without shorting the stock, which would require borrowing shares and carries losses that have no ceiling if the price rises.

Income

Writers collect premium in exchange for taking on an obligation. Covered calls and cash-secured puts are the common income approaches. The trade-off is a capped gain (the premium, plus any stock appreciation up to the strike on a covered call) against losses that can be large if the underlying moves sharply.

Multi-leg strategies

Options can be combined with each other and with the underlying to shape a payoff. Common structures include:

• Vertical spreads (bull call, bear put): buy one option and sell another of the same type with a different strike, reducing cost and capping profit.
• Straddles and strangles: buy a call and a put to profit from a large move in either direction. See how a straddle works.
• Butterfly spreads: three strikes combined to profit if the underlying stays near a target.
• Calendar spreads: same strike, different expirations, to profit from differences in time decay.
• Collars: own the stock, buy a protective put and sell a covered call to finance it.

Limitations and Risks of an Options Contract

• Total loss of premium. A bought option that expires out of the money is worth nothing. In the leverage example, a stock that went nowhere produced a 100% loss on the option position.
• Time decay. Being right about direction but wrong about timing still loses money, because the move must outrun the decline in time value.
• Uncapped losses for writers. An uncovered call writer’s loss has no ceiling; a put writer can lose up to the strike minus the premium per share.
• Assignment risk. Writers of American-style options can be assigned before expiration, which can happen around ex-dividend dates on calls or when puts are deep in the money.
• No ownership rights. Holding a call is not owning the stock: no dividends and no voting rights until exercise.
• Liquidity and costs. Options on less actively traded underlyings or at distant strikes can have wide bid-ask spreads, and per-contract fees add up across multi-leg trades. Open interest, the number of contracts outstanding, is one gauge of how active a specific contract is.
• Margin requirements. Writing options usually requires margin, and requirements can rise when the market moves against the position.

In the US, brokers must approve accounts for options trading and assign approval levels that determine which strategies a client may use. Uncovered writing typically sits at the highest level. Exchanges also set position limits that cap how many contracts on one underlying a single account or group of related accounts can hold.

Options Contracts vs. Other Contracts

Options vs. futures and forwards

A futures contract obligates both parties to buy and sell at the agreed price on the delivery date. A forward does the same privately, without exchange standardization. Neither has an upfront premium in the option sense: futures require margin deposits, and both sides face gains and losses as the price moves. An option obligates only the writer; the buyer can walk away and lose no more than the premium.

Listed options vs. employee stock options

Employee stock options granted as compensation are call options in economic terms, but they are not standardized exchange contracts. They typically have vesting schedules, are issued by the company itself, and generally cannot be sold or transferred. Employees realize value by exercising and then holding or selling the resulting shares. Warrants are similar company-issued rights, sometimes traded, with longer lives than most listed options.

The option contract in contract law

Outside finance, an option contract in contract law is an agreement that keeps an offer open for a fixed period, usually because the offeree pays something (consideration) for the offeror’s promise not to revoke it. A buyer who pays a property owner to hold a sale price for 60 days has an option contract in this sense. The structure mirrors a financial call: a paid-for right, not an obligation, to complete a transaction on set terms.

How to Buy an Options Contract

1. Open an options-enabled brokerage account at the approval level your strategies need. US brokers provide the standardized options risk disclosure document before approval.
2. Choose the underlying, outlook and expiration: a call for an expected rise, a put for an expected fall or for protection, with an expiration that matches the expected move. Shorter expirations cost less but decay faster.
3. Select the strike: ITM strikes cost more and carry more intrinsic value; OTM strikes cost less and need a larger move to pay off.
4. Calculate cost and break-even with the formulas above, including commissions.
5. Place a buy-to-open limit order to set the maximum premium you will pay, which matters when bid-ask spreads are wide.
6. Plan the exit: when you will sell to close, when you would exercise, and what happens at expiration if you do nothing.

The Bottom Line

Options matter to investors who want to hedge holdings, speculate with limited capital or earn income from writing contracts. Buyers can lose no more than the premium but face time decay and total loss if the option expires out of the money, while uncovered writers face losses with no ceiling. Before trading, calculate cost and break-even, use limit orders and plan how the position will close.