Stock Option Contract Anatomy

A stock option is a standardized contract concerning either the purchase or sale of a specific security at a set price.

A stock option, or options on futures or an index, all share common attributes.  Each option, at its most basic level, is simply a contract that gives the holder of the option the right to buy or sell a specific security.  That security might be a stock, an index, or a futures contract. 

Option Type: Call Option versus Put Option

Options come in one of two flavors: calls and puts.  As the buyer of a call option, you have the right to purchase the underlying security.  The seller of a call option collects a premium for the sale, but must stand ready to deliver the underlying security to the option holder if called upon to do so.

Conversely, the put option buyer has the right to sell the underlying security.  The person selling the put option must take delivery of the underlying contract, should the holder of the put option choose to exercise their right to do so.

Option Strike Price

Each option contract carries a specified price at which the underlying security is to be bought or sold.  This "strike price," as it is called, is the price at which the owner of the call may purchase the underlying security and the price at which the owner of the put option may sell the underlying security.  Those who have sold the options are obligated to buy, or sell, at the strike price.

Option Expiration Date

Options have finite life spans.  Each option carries an expiration date.  Index and stock option contracts have been standardized and expire on the Saturday following the third Friday of each month of their designated month.  For example, a December option will expire on the Saturday following the third Friday in the month of December.  The expiration date for futures options vary.

The expiration date is the date by which the option position must either be closed or exercised.  If an option position remains opened on the expiration date, it will expire worthless.  Most brokers will automatically execute an option contract for their clients, if the underlying security's price exceed the strike price of a call option or is lower than the strike price of a put option.

Option Contract Review and Example

Options are either call options or put options. 

The buyer of a call option has the right, but not the obligation, to buy the underlying security at the specified strike price.  The seller of the call option has the obligation, but not the right, to sell the underlying security at the specified strike price.

Assume that today is March 1rst and the stock price of XYZ Company is currently at $30 per share.  You are bullish on the stock, believing that in the next week the company's share price will climb to $35 per share.  You buy an April $30 XYZ Call option, which gives you the right to buy XYZ stock at $30 between now and the Saturday following the third Friday in April.  If XYZ does trade up to $35 per share, you may exercise your rights to buy the stock at $30.  If the stock price failed to climb, your option would expire worthless unless closed out prior to the expiration date.

The buyer of a put option has the right, but not the obligation, to sell the underlying security at the specified strike price.  The seller of the put option has the obligation, but not the right, to buy the underlying security at the specified strike price.

It is now April 15th and XYZ company now trades at $28 per share.  You remain bullish on the stock and sell the May $27.50 XYZ Put, receiving a $1.00 premium for the sale.  You are now obligated to buy XYZ stock at $27.50 per share, if the put contract is exercised.  By the May expiration date, the stock has traded to $28.75 and the put option expires worthless.  Your position is now closed and any obligation is ended.  You keep the cash premium received from the sale.

Recommended Resources

McMillan on Options, 2nd Ed.
A complete review of options and
their uses.  A 'must have' book.

Getting Started in Options
An easy-to-read guide to the
complex world of options.