Options Contracts Explained - What Every Beginner Needs to Know

Introduction: The Building Block of All Options Trading

Every trade you make in the options market is built on one thing: the options contract.

If you don’t fully understand what an options contract is, what it represents, how it works, and what rights and obligations it carries, everything else becomes guesswork.

This isn’t just vocabulary. This is the foundation of options trading success.

Let’s break it down in plain English.

What Is an Options Contract?

An options contract is a legally binding agreement between two parties that gives one party the right (but not the obligation) to buy or sell an asset at a predetermined price within a specific period of time.

Each standard contract controls 100 shares of the underlying stock or ETF.

There are two types of contracts:

• Call Options: Give the buyer the right to buy shares at a set price (the strike).

• Put Options: Give the buyer the right to sell shares at a set price.

In both cases, the seller (or writer) of the option takes on an obligation, to sell (in the case of calls) or to buy (in the case of puts) the underlying shares if the buyer chooses to exercise their rights.

The Key Terms Every Options Trader Must Know

To understand how options contracts work, you need to know five key terms:

1. Underlying Asset

This is the stock, ETF, or index the contract is based on. Think of it as the “target” security.

2. Strike Price

The agreed-upon price at which the buyer can buy (call) or sell (put) the underlying asset.

3. Expiration Date

The deadline by which the buyer must decide whether to exercise the option. After this date, the contract expires worthless if not exercised or closed.

4. Premium

The price the buyer pays to the seller for the rights in the contract. It’s quoted on a per-share basis, so a $2 premium equals $200 total for one contract.

5. Contract Size

One standard options contract represents 100 shares of the underlying stock.

A Real-World Example: Selling a Cash-Secured Put on NVDA

Let’s say you’re willing to buy 100 shares of NVDA, which is currently trading at $155, but you’d prefer to get paid to wait for a better price.

Instead of placing a limit order, you decide to sell a cash-secured put, a strategy that pays you upfront in exchange for taking on the obligation to buy shares if they fall below your strike.

Trade Setup

• Underlying Stock: NVDA

• Current Price: $155

• Strike Price: $150 put

• Expiration: 30 days out

• Premium Received: $3.40

• Total Premium Collected: 100 × $3.40 = $340

• Capital Secured: $15,000 (to buy 100 shares at $150)

✅ Scenario 1: NVDA Stays Above $150 at Expiration

• The put expires worthless

• You keep the full $340 premium

• No shares are assigned

• Return on Capital = $340 / $15,000 = 2.27% in 30 days

Annualized (simple approximation):
2.27% × 12 = 27.2% annualized

✔️ This is the ideal outcome for put sellers, get paid and never own the stock.

✅ Scenario 2: NVDA Falls Below $150 at Expiration (Say, Closes at $145)

• You’re assigned 100 shares of NVDA at $150

• Your effective cost basis = $150 – $3.40 = $146.60

• NVDA is trading at $145, so your unrealized loss is:
  $145 – $146.60 = –$1.60 per share, or –$160 total

But remember:
You now own shares you wanted at a lower price than they were trading a month ago, and you were paid $340 for taking that risk.

✅ Scenario 3: NVDA Crashes to $130

• You’re still assigned at $150

• Cost basis remains $146.60

• Shares are now worth $130 → Unrealized loss = –$16.60/share = –$1,660

This highlights the key risk:
Cash-secured puts have limited upside (the premium) and significant downside (the stock collapsing far below the strike).

But, this is no worse than buying 100 shares at $155 outright. In fact, it’s better because your effective entry is lower and you were paid to wait.

Trade Summary Table

Key Takeaways

• Max profit = Premium collected = $340

• Max loss = Same as owning stock, downside if NVDA drops below breakeven

• Breakeven = Strike Price – Premium = $146.60

• You’re paid to take the risk of buying the stock

• If assigned, you own shares at a discount to today’s price

This strategy works best when:

• You want to own the stock anyway

• You’re happy with the strike as a buy-in price

• You’re managing risk through diversification, position sizing, and market context

The Role of the Buyer vs. Seller

Understanding who takes on risk in an options contract is key.

Buyers have limited risk (the premium paid) and unlimited potential (on calls). Sellers take on more risk in exchange for a premium upfront.

Why Options Traders Use Contracts

Options contracts are powerful because they let traders:

• Control more shares with less capital (leverage)

• Hedge risk in stock portfolios

• Generate income through premium collection

• Speculate on price direction, volatility, or time decay

Whether you’re an income trader selling cash-secured puts, or a directional trader buying calls on momentum setups, it all comes back to mastering contracts.

Expiration Styles: American vs. European

Not all options behave the same.

• American-style options (most stocks/ETFs): Can be exercised anytime before expiration.

• European-style options (many index options): Can only be exercised on the expiration date.

For example, SPY options are American-style. SPX options are European-style.

This distinction matters for strategy design, especially around dividend dates or high-volatility events.

Cash-Settled vs. Physically-Settled Contracts

Most options on stocks result in physical settlement, you buy or sell actual shares if exercised.

Some index options are cash-settled, no shares change hands. Instead, your profit or loss is settled in cash.

Why it matters: If you’re trading a high-dollar name or an index contract, knowing the settlement type can impact your margin, tax treatment, and exposure.

How Are Options Contracts Traded?

Options contracts are bought and sold on regulated exchanges like the CBOE (Chicago Board Options Exchange), through brokers such as Tastytrade, Interactive Brokers, Schwab, or Fidelity.

The Options Clearing Corporation (OCC) guarantees each contract, reducing counterparty risk for both sides of the trade.

Why Options Expire

Options don’t last forever. They are time-sensitive agreements, which is why the passage of time (Theta) is such a powerful force in options pricing.

Most traders either:

• Sell the contract before expiration to realize gains or cut losses

• Let it expire (if worthless or out-of-the-money)

• Exercise it (rare for most retail traders, but possible)

Final Word: Contracts Are Tools, Not Lottery Tickets

Options contracts aren’t magic. They’re financial tools, and like any tool, they can help or harm depending on how they’re used.

The biggest mistake beginners make? Treating contracts like lottery tickets. Buying cheap out-of-the-money calls or puts hoping for a miracle move.

Instead, focus on understanding what you own, why the premium is priced the way it is, and how time, volatility, and direction work together.

Because once you truly understand what an options contract is, every strategy, from covered calls to iron condors, starts to make a lot more sense.

Suggested Reading

• ➡️ The All-Weather Portfolio with Poor Man’s Covered Calls: A Tactical Approach to Consistent Income

• ➡️ Mastering the Iron Condor: A Step-by-Step Comprehensive Guide to a Defined-Risk Options Strategy

• ➡️ Options Traders' Must-Have: Mastering the Expected Move

Want More Options 101 Lessons?

This article is part of our Options 101: First Steps to Trading series at The Option Premium, designed to build a rock-solid foundation for options traders.

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