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Like any formal agreement between two parties, option contracts clearly delineate all of the parameters of the contract between buyer and seller. In this article, we’ll explain each of the five key option contract specifications in detail.
Here is an example of an option contract:
The pieces of this agreement specify the following:
Option contracts are an agreement to either buy or sell 100 shares of stock. We need to specify which stock we are trading through the option contract. In our example, “XYZ” is the stock symbol that we are trading. “XYZ” could be any stock that has option contracts – Apple, Facebook, Boeing – just to name a few. The underlying stock price is one of the key inputs into the option pricing model, so this is a key piece of information when trading options.
Option contracts have a finite life. The expiration date tells us when the option contract will expire. In our example, “February” represents the time of expiration. Monthly options expire on the third Friday of the month: a “February” expiration option like this one will expire on the third Friday in February.
It is important to note that there are also weekly expiration dates. Weekly expiration options expire on Friday of that week. At Option Posts, however, we prefer to stick with monthly expiration contracts because weekly contracts tend to be less liquid, which is an important factor that we consider.
The third option contract specification is the strike price. Option contracts are an agreement to either buy or sell stock at a certain price in the future. This is a different number from the current stock price. The strike price specifies the price at which the stock transaction will take place, even if the stock price is currently trading at a different price. In our example, the strike price is 50. This means that the option buyer and the option seller agree to transact stock at a price of $50 per share should the option buyer choose to “exercise,” or use, the contract, even if the stock is trading at a different value, say $48, at the time the contract is made.
Next, we must specify whether it is a call contract or a put contract. This indicates whether the option buyer wants to buy stock with a call contract, or sell stock with a put contract. In our example, it is a “call” contract, meaning the option buyer has the right but not the obligation to buy 100 shares of stock at the strike price at any point in the future up until the expiration date.
Lastly, we have to indicate the price or premium paid for the option contract. This is the price that the option buyer and option seller agree upon to initiate the option contract.
In our example, the price of the option contract is $1.50. This means that the option buyer would pay $1.50 per share (or $150 total) to the option seller in exchange for entering into the option contract.
As option sellers, we receive a credit for initiating a trade. You can check out why we choose to sell options and receive a credit over buying options in this post.
Putting together the 5 pieces of an option contract gives us our example from above:
This contract is a 50-strike call option on XYZ stock that expires on the third Friday in February. In exchange for this agreement between the buyer and seller, the buyer will pay $1.50 per share to the seller, or $150 in dollar terms. The contract buyer now has the right, but not the obligation, to buy 100 shares of stock at or before the time at which the contract expires.
This is the foundation for options trading. It may seem difficult or confusing now, but just keep working at it. Check out our blog for more options trading education.
If you are unsure of any of the terms used in the article, check out our list of the 66 most common option terms explained here.
If you learned anything about the 5 Key Option Contract Specifications, let us know in the comment section below!
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