An option agreement is a contract giving an individual the right to purchase an item for a given price, although such a purchase is not required. Option agreements are common in business and real estate. Such agreements also exist in the stock market.
When an option agreement is written, it generally names a price for an item and gives a person the option to buy the item at that price. For example, an option agreement could give an individual the right to buy a share of stock in a company at $100 US Dollars (USD). The individual would then be entitled to buy the stock at $100 USD per share, but would not have to do so.
Generally, a person pays a fee for an options contract. That fee is buying the guaranteed price. The fee varies depending on the nature of the contract.
Although options agreements exist in many forms, including business, understanding how stock option agreements work is generally the easiest way to understand options. Assume, for example, that a stock is currently selling at $10 USD per share. An options contract could grant an investor the right to buy a single share of the stock for either $9 per share or to buy a share of the stock for $11 USD per share.
The option contract to buy the stock at $9 USD per share is referred to as "in the money" because if the investor purchases that option, he can buy the stock for $1 USD less than what it is currently selling for, making an instant $1 USD profit. On the other hand, if he bought the option to buy the stock for $11 USD per share, the investor would only make money if the stock closed above $11 USD per share. If the stock went up to $11.50 USD per share, the investor could exercise his option, which means he could buy the stock at the $11 USD he was promised; if the stock did not go above $11 USD, he could allow his option to expire and only lose his initial investment.
An option agreement generally carries an expiration date. If the option is not exercised within the given period before it expires, then the individual loses his right to buy the item at the promised price. The time period the option is good for varies depending on the type of option agreement written.