A stock option is a contract between two parties where one party agrees to supply the other of a specified number of shares of stock, at a specified price, within a given period of time.

There are two types of option: puts and calls.  Each option contract has a similar structure.  For a given company, only the price and time period differ.  Let's used the hypothetical XYZ Company again and discuss a Call Option and a Put Option.

Call Option

So imagine a person expects shares of XYZ Corporation to increase in value and wants to benefit from that without necessarily owning the shares.  The person could buy a Call Option contract covering 1,000 shares.  The contract has a number of components:

• The strike price: the price at which the shares may be purchased;
• The expiration date: the date after which the contract is invalid;
• The number of shares: more on this topic later.

The strike price is the price at which the owner of the contract can purchase the shares regardless of the market price.  So, in the hypothetical example, if XYZ Company is today trading at $10 and the strike price is $15, even if the shares climb to $20, the owner of the contact is entitled to buy them at $15 each.  Strike prices are standardized.  The discussion later gives some examples.

The expiration date is pretty self explanatory.  If the owner wishes to exercise his or her right to buy the shares, it must be done before the contract expires.  Expiration dates are standardized.  Contracts are written initially for six months and expire on the third Friday in that sixth month.  LEAPs are a slightly different animal.  These contracts are written for up to three years and expire at the end of January.

Finally, the number of shares needs to be discussed.  The number of shares in an option contract has been standardized too.  Contracts are traded in quantities of 100 shares each.  So, 10 contracts represent 1,000 shares. 

To buy an option contract, there's a price and commission.  The commission is either a flat fee, or, more likely a flat fee plus an additional charge per contract.  So, for the 1,000 shares of XYZ Company, the brokerage company may charge the client the normal brokerage commission of $9.99 pus a charge of $1.50 for each of the ten contracts.  The price of each contract (remember each contract covers 100 shares) depends on the expiration date: the close you are to expiration, the lower the price.  It depends on the strike price: the closer the strike price is to the current market price, the higher is the price of the contract.  For XYZ Company, trading at $10, if the strike price is $12.50 with an expiration in two months, the price per share might be 75¢, so the buyer of the contract pays a commission plus $750 for the right to buy the shares at a later day.

If XYZ Company is trading at $10 a share, and a person wants to have call options for 1,000 shares, then for the same expiration date, a contract with a strike price of $12.50 is more expensive than a contract for $15.00, which is in turn more expensive than a contract for $17.50.  Alternatively, if the person decides that he or she wants to have a strike price of $12.50, then a contract that expires in ten days is less expensive than a contract expiring in three months.

Sitting at the other end of the contact is the person who wrote it: the person who probably doesn't expect the shares to increase dramatically in the next few months.   When the person writes the contract, he or she pays a commission but, using the example above, earns the $750 that the buyer of the contract paid.

If the contacts expire and the market price is below the strike price, the owner of the contract loses.  However, if the market price is above the strike price, the writer of the contact has to deliver the specified number of shares to the buyer.  If the writer doesn't own those shares, then he or she wrote a naked contract.  The writer is required to buy the shares in the open market, then transfer them to the owner at the strike price: the writer is out the difference.

In reality, the process is standardized, so people aren't required to purchase shares: the funds are just deducted from the persons account.  Also most people trade option contracts rather than demand delivery of shares of common stock.

Put Option

A put option is the mirror image, in may respects, of the call option.  It has all the same characteristics of a call option–strike price, expiration date, etc.–except there is an expectation that the stock price could fall.  Rather than buy shares of stock, a put option gives the owner the right to sell shares of stock.  On the other end of the contract, the writer, rather than promising to sell shares, promises to buy them.

So for the case of XYZ Company trading at $10, the price of a put option with a strike price of $7.50 would be lower than a similar contract with a strike price of $12.50.  Why?  Since the contract gives the owner the write to sell shares, no one would agree to buy shares for $12.50 each when he or she can buy them on the open market for $10.  The price of the contact is at least $2.50 a share, and likely higher.  Conversely, if the strike price is $7.50 and the market price is $10, the owner of the contact would be sort of crazy to sell the shares at a discount of $2.50 each.   The writer of the contact is happy to purchase shares at $7.50 each, given that the market values them at $10.

People often use option contacts as a complement to their investment in shares.  If a person owns 1,000 of XYZ Company, writing ten Call Contacts for those 1,000 shares is a good way to generate some extra revenue, particularly if that person doesn't expense the stock price to rise dramatically.  Similarly, if there is a risk that the shares could drop in value, a good way to protect downside is to enter into a Put Option Contract that protects downside.