Lesson 1 of 20 · 6 min

What an option contract is: rights and obligations

An option is an agreement where one side holds a right and the other side holds an obligation.

Strip away the jargon and an option is a contract between two parties about a future transaction that may or may not happen. One party pays for the right to require that transaction. The other party is paid to be required.

That asymmetry is the entire structure. The holder — the party who paid — decides. The writer, sometimes called the seller, does not decide; they must perform if the holder says so. The payment for this arrangement is the premium, and it changes hands at the start and is not returned.

The five things that must be specified for the contract to mean anything:

The underlying: what asset the future transaction concerns.
The type: whether the right is to acquire or to dispose.
The strike: the price at which that transaction would happen.
The expiry: the last date the right can be used.
The size: how many units one contract covers, conventionally 100 shares for listed equity options.

One consequence follows immediately and explains most of what comes later. Because the holder holds a right and not an obligation, the worst case for the holder is that the right goes unused and the premium is gone. Because the writer holds an obligation and not a right, the writer's worst case is bounded only by how far the underlying can move. The two sides of the same contract have shapes that are nothing alike.

Every subsequent lesson in this track is a detail of this structure: what the right is, when it can be used, what performing the obligation involves, and how the market prices the gap between them.

Key terms

Option: A contract giving one party the right, and the other party the corresponding obligation, to transact in an underlying asset at a set price by a set date.
Premium: The price paid by the holder to the writer for the contract. Paid up front, not refundable.
Holder and writer: The holder paid for the right and chooses whether to use it. The writer was paid and must perform if asked.
Contract multiplier: How many units of the underlying one contract covers. Conventionally 100 shares, so a $2.50 quoted premium costs $250.

Worked example

Reading one contract as a sentence

One contract: underlying XYZ, call, strike $50, expiry in 60 days, premium quoted $3.20.

What the holder acquired: The right to acquire 100 shares at $50
What the writer accepted: The obligation to deliver 100 shares at $50 if asked
Cash paid by the holder: $320
Cash received by the writer: $320
Last day the right exists: Day 60

A quoted premium is per share; the contract is per hundred. Confusing the two misstates every position size by a factor of 100.

Check yourself

In an option contract, which party decides whether the underlying transaction happens, and which party has the unbounded exposure?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.