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The Option Contract
As mentioned in the first lesson on this section, the option contract gives the buyer or "holder" of the right, but not the obligation to or buy or sell shares of the underlying security at a specified price on or before a given date. The holder of an option is not obligated to do anything with the option once it has been purchased. You may be thinking that is fine for the holder but all option contracts have two sides, what about the seller?
The seller or option "writer" is obligated to perform according to the terms of the option contract sold. In our example, the writer of the IBM November 100 calls is obligated to sell 100 shares of IBM Corp. at $100 any time prior to expiration if the option buyer chooses to evoke their right to exercised. Similarly, the writer of IBM November 100 puts is obligated to buy 100 shares of IBM Corp. at $100 any time prior to expiration if the option is exercised by the holder. The writer must fulfill their end of the contract regardless of price. What does the writer get for this obligation? That's easy, the writer receives the premium paid by the buyer. Regardless of what happens to the underlying common stock, the writer gets to keep the entire premium.
You will note that we have tried to subtly introduce two new terms; holder and writer. Let's make this extra clear. The holder is always the buyer of an option contract and the writer is always the seller. It makes good sense really, if you buy an option you get to hold it and if you sell an option contract you get to write it.
About now it is pretty easy to think that there are millions of investors out there writing and buying innovative option contracts but think again. All option contracts traded on U.S. securities exchanges are issued, guaranteed and cleared by the Options Clearing Corporation (OCC). That means they are standardized.
Now let's take a closer look at the components of the option contract.