A stock option contract is a tradable agreement that gives the buyer the right to buy or sell 100 shares of a specific stock at a fixed price before a set deadline, and obligates the seller to honor that right if the buyer uses it. The buyer pays a non-refundable price called the premium for that right. These contracts trade on regulated exchanges under Securities and Exchange Commission oversight, and every trade is guaranteed by the Options Clearing Corporation, which sits between buyer and seller so neither side has to trust the other.1The Options Clearing Corporation. Clearance and Settlement
One contract covers 100 shares. That’s the single most important number to keep in mind, because every price you see quoted is per share and needs to be multiplied by 100 to get the real dollar figure.
The Four Terms That Define Every Contract
Before an option can trade, four things have to be nailed down. Together they describe exactly what you’re buying or selling.
- Underlying security. The specific stock the contract is tied to. Its price movement is what makes the contract gain or lose value.
- Strike price. The fixed dollar price at which the shares can be bought or sold under the contract. It’s locked in when the contract is written and doesn’t move afterward.
- Expiration date. The deadline. Standard monthly options expire on the third Friday of the contract month. Weekly options expire every Friday. Long-term contracts called LEAPS (Long-Term Equity Anticipation Securities) can run out to roughly three years, with January expirations only.2Cboe Global Markets. Equity LEAPS Options Product Specifications
- Premium. The price the buyer pays the seller for the contract. Premiums are quoted per share, so a premium of $3.00 costs $300 for one contract. If you buy the contract and never use it, that premium is the most you can lose.
Calls and Puts
Every option is either a call or a put. That single choice determines whether you’re betting the stock goes up or down, and whether you’d be buying or selling shares if the contract gets used.
A call gives the holder the right to buy 100 shares at the strike price. If you hold a call with a $50 strike and the stock climbs to $80, you can still buy at $50. Your profit is the difference between market price and strike, minus the premium you paid. If the stock never rises above the strike, you let the contract expire and lose only the premium. The appeal is leverage: buying 100 shares of a $50 stock costs $5,000, while a call on the same shares might run $300. You control the same exposure for a fraction of the capital, on the condition that the move happens before expiration.
A put gives the holder the right to sell 100 shares at the strike price. Hold a put with a $60 strike and watch the stock drop to $35, and you can still sell at $60. Profit is the strike minus the market price, minus premium. If the stock stays above the strike, the put expires worthless.
Puts have a practical use beyond speculation. If you own shares at $100 and want protection against a drop, buying a $95 put guarantees you can sell at $95 no matter how far the stock falls. It works like insurance, with the premium as the cost. Unlike a stop-loss order, which can trigger on a brief intraday swing and lock in a loss before the stock recovers, a put lets you decide whether and when to sell all the way through expiration.
Buyer’s Rights, Seller’s Obligations
An option contract is asymmetric on purpose. The buyer (holder) has rights but no duty to act. The seller (writer) collects the premium up front and takes on an obligation to perform if the buyer decides to use the contract.
If you’re the buyer, your worst case is losing the premium. That’s the whole point of paying it. You choose whether to exercise, sell the contract to someone else, or let it expire.
If you’re the seller, the picture depends heavily on whether the position is covered. A covered call writer already owns the 100 shares and simply agrees to hand them over at the strike price if assigned. The downside is capped: you might be forced to sell your shares below the current market, but you can’t lose more than that.
A naked call writer doesn’t own the shares. If the stock surges and the buyer exercises, the naked writer has to buy shares at the current market price and deliver them at the lower strike. A stock can rise without a ceiling, so the potential loss on a naked call is unlimited. Brokerages restrict naked positions to their highest options approval levels and require substantial margin collateral to back them up.3FINRA. FINRA Rules – 4210 Margin Requirements Writers who can’t meet margin or delivery obligations face forced liquidation.
In the Money, At the Money, Out of the Money
These three phrases describe where a contract stands relative to the current stock price, and they show up in every option quote.
A call is in the money when the stock trades above the strike, because exercising would let you buy below market. A put is in the money when the stock trades below the strike. When the stock sits right at the strike, the contract is at the money. When exercising would produce no benefit, it’s out of the money. This status directly affects the premium you pay and, at expiration, whether the contract gets exercised automatically.
When You Can Exercise
Most equity options in the United States are American-style, meaning the holder can exercise any time before expiration. Hit your target price two weeks early, and you can act that day. European-style options can only be exercised on the expiration date itself, and index options like those on the S&P 500 usually follow that style. The practical difference lands on sellers: an American-style writer can be assigned any trading day, while a European-style writer only faces assignment once.
Early assignment shows up most often in one specific setup. When a call you wrote is deep in the money just before the stock’s ex-dividend date, the holder has an incentive to exercise early and collect the dividend. If the option’s remaining time value is less than the upcoming dividend, early exercise is close to a sure thing. Sellers who aren’t watching for it can end up short shares unexpectedly.
What Happens at Expiration
Something that surprises newer traders: you don’t have to manually exercise an in-the-money option at expiration. The OCC’s “exercise by exception” procedure automatically exercises any expiring option that finishes at least $0.01 in the money, unless you instruct your broker otherwise.4U.S. Securities and Exchange Commission. Rule 1100 – Exercise of Options Contracts Hold a call with a $50 strike, the stock closes at $50.01 on expiration Friday, and you’ll receive 100 shares whether you planned on it or not.
To block automatic exercise, you submit a “contrary exercise advice” through your broker. The general deadline for final exercise instructions is 5:30 p.m. Eastern Time on the business day before expiration; brokers have until 7:30 p.m. Eastern to send customer contrary instructions to the exchange.4U.S. Securities and Exchange Commission. Rule 1100 – Exercise of Options Contracts If you don’t want that in-the-money option exercised, tell your broker well before those cutoffs.
Settlement itself takes two forms. Equity options on individual stocks and ETFs use physical delivery: actual shares move between accounts. Exercise a call on Apple, and 100 shares of Apple land in your account. Index options are cash-settled, because you can’t deliver shares of an index. The OCC calculates the difference between the strike and the settlement value, applies the contract multiplier, and moves the resulting cash.5Cboe Global Markets. Why Option Settlement Style Matters Since May 2024, U.S. securities transactions settle on a T+1 basis, so the transfer finalizes one business day after exercise.6U.S. Securities and Exchange Commission. SEC Chair Gensler Statement on Upcoming Implementation of T Plus 1
Getting Approved to Trade Options
You can’t open a brokerage account and immediately sell naked calls. Brokerages assign options approval levels based on your experience, income, net worth, and stated objectives. Labels vary, but most firms use a four-tier structure:
- Level 1. Covered calls and cash-secured puts. You either own the underlying shares or hold enough cash to buy them if assigned. This is where most investors start.
- Level 2. Buying calls and puts outright. Your maximum loss is the premium, so the risk is defined.
- Level 3. Spread strategies combining multiple contracts at different strikes or expirations. More moving parts, more knowledge required.
- Level 4. Naked calls and puts. Because losses can be effectively unlimited, this level requires experience, high net worth, and significant margin capacity.
Expect to start at Level 1 or 2. Brokerages can also downgrade or revoke approval later based on account activity or changes in your financial profile.
Taxes on Option Contracts
Option gains and losses are treated as capital gains and losses. Whether the result is short-term or long-term depends on how long you held the option itself, not the underlying stock. Hold longer than a year and it’s long-term; a year or less makes it short-term.7Internal Revenue Service. Topic No 409 – Capital Gains and Losses Because standard options expire within months, most option gains end up taxed at the higher short-term rate. When an option expires worthless, the premium becomes a capital loss, and the holding period runs from purchase to expiration.8Internal Revenue Service. Publication 550 – Investment Income and Expenses
Index options and certain other “nonequity” options get different treatment under Section 1256 of the Internal Revenue Code. Regardless of holding period, 60% of the gain is taxed at the long-term rate and 40% at the short-term rate. Standard options on individual stocks are classified as “equity options” and excluded from Section 1256 unless you’re a registered options dealer.9Office of the Law Revision Counsel. 26 USC 1256 – Section 1256 Contracts Marked to Market
The wash sale rule applies to options the same way it applies to stock. Sell an option at a loss and buy a substantially identical one within 30 days before or after the sale, and the IRS disallows the loss. The disallowed amount gets added to the basis of the replacement position, deferring the deduction instead of eliminating it.10Internal Revenue Service. Case Study 1 – Wash Sales Brokers flag wash sales on Form 1099-B, but tracking them across multiple accounts is on you.