An option contract is an agreement between a buyer and seller, wherein the seller gives the buyer the right to buy (in this case it is called a ‘call option’) or sell (in this case it is called a ‘put option’) a specific asset at a predetermined rate on or before a specific date. The buyer of the option is also known as an option holder, while the seller is also called the writer of the option.

The option holder may or may not exercise his option to buy or sell the asset but the option seller has to comply with the wishes of the option holder, if he decides to exercise his option.

Although it is called an option contract, in reality no physical agreement is entered into and signed by the buyer and the seller. Transactions are conducted through the stock exchange and settlement is taken care of by the clearing house and the stock exchange. 

Now let’s look at some terminology pertaining to options before we tie them all together, in the form of an illustration.