Terms of an options contract

Options are structured as contracts that establish a trade agreement between two counterparties. The value of a given option is derived from a variety of factors primarily related to the underlying asset. As such, it is a derivative instrument.

There are two forms in which option contracts are traded:

  • Exchange-traded options are standardized and are settled through a clearing house.
  • Over-the-counter options are unrestricted arrangements created between two private parties.

The remainder of this course will primarily focus on exchange-traded US equity options.

Understanding the terms of an option contract

An option contract is made up of four key terms.

Underlying: What the option controls

The most important part of an option contract describes the underlying instrument. This can be an equity, an index, a commodity, or anything else two parties are agreeing to potentially trade. Standard US equity options operate in 100-share lots. In other words, a single option contract controls the rights to 100 shares.

Type: What transaction the option represents

When an option contract is exercised, its specified transaction is executed. There are two types of options:

  • Call options grant the holder (buyer) the right, but not the obligation, to buy the underlying stock. The counterparty, otherwise known as the seller or writer, is obligated to sell the stock if the holder exercises the contract.
  • Put options grant the holder the right to sell the underlying stock. The writer is obligated to buy the stock if the contract is exercised.

It’s important to understand that a call is not the opposite of a put. They are distinct types of options that offer opposite exercise behaviors relative to the underlying asset. However, buying a call is not the opposite of buying a put for a variety of reasons that should become clear by the end of this course.

Strike: The price the option transaction executes at

When an option contract is exercised, it will result in the purchase or sale of the underlying. The strike price defines the price at which this transaction executes.

Expiration: The last date the option may be exercised

Option contracts are created with a specific expiration date. For US equities, this is the final date on which the contract may be exercised. Almost all contracts expire on the last trading day of their week, which is usually a Friday. However, some available options expire on Mondays or Wednesdays.

Exercise styles

Options on different asset classes often follow different policies regarding when an option may be exercised. In the US equity option market, there are two of relevance:

  • American-style options may be exercised at any point at or before expiration. All exchange-traded US equity options use this policy.
  • European-style options may only be exercised at expiration. While no equities use this policy, it is used by options on equity indexes, such as the S&P 500. However, this point is somewhat moot since index options are cash-settled anyway as there is no underlying asset to deliver.

Reading an option symbol

Every option contract sharing the same underlying, type, strike, and expiration is identical and belong to the same option series. These contracts all share the same option contract symbol, similar to the way all shares for a given stock symbol are identical.

Consider a call option on stock XYZ struck at 100 expiring January 15, 2021. In most platforms, you’ll see something user-friendly, such as XYZ 100 Call 15-Jan-2021.

However, there is also a standard convention that encodes the information into a condensed string using the format below:

[underlying][2-digit year, month, and day of expiration][type as C or P][8-digit strike x 1000]

The symbol for the option above would be XYZ210115C00010000.