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Option contract

An option contract is a type of contract in which the offeror promises to keep an offer open for acceptance by the offeree for a specified period, in exchange for consideration provided by the offeree.^[1] This prevents the offeror from revoking the offer during that time, providing the offeree with a protected opportunity to decide whether to enter into the underlying contract.^[2] Option contracts are distinct from financial options, which are derivatives traded on exchanges; here, the term refers specifically to this mechanism in common law contract doctrine.^[1] They typically require three essential elements: a valid offer, separate consideration (often nominal, such as one dollar), and clear terms specifying the duration the offer remains open.^[3] Once the consideration is given, the option contract becomes irrevocable, and if exercised within the period, it leads to a binding bilateral contract.^[4] In practice, option contracts are used in real estate (e.g., to secure purchase rights), mergers and acquisitions, and other transactions where time is needed for due diligence or financing.^[2] They play a key role in contract theory by addressing issues of offer revocability and promissory estoppel, topics explored further in specialized sections of this article.

Fundamentals

Definition and Purpose

An option contract is a distinct type of contract in which one party, known as the optionor, promises to keep an offer open for acceptance by the other party, the optionee, for a specified period of time in exchange for consideration.^[1] This agreement binds the optionor to refrain from revoking the underlying offer during the option period, thereby transforming what would otherwise be a revocable offer into an irrevocable one.^[5] The primary purpose of an option contract is to provide stability and certainty in negotiations by protecting the optionee from the risk of offer revocation, which allows the optionee time to evaluate the offer, secure financing, or conduct due diligence without fear of losing the opportunity.^[2] This mechanism facilitates deal-making in uncertain environments, such as real estate transactions or business acquisitions, where the optionee may need time to assess market conditions or perform necessary preparations.^[1] By creating a binding commitment, the option contract encourages reliance on the offer and promotes efficient contractual planning.^[2] Key characteristics of an option contract include its irrevocability during the specified period, which distinguishes it from ordinary offers that can be withdrawn at any time before acceptance, and from mere reservations of rights that lack the binding promise supported by consideration.^[5] Unlike a standard bilateral agreement, an option contract often arises in the context of unilateral contracts, where the optionee's performance would otherwise trigger the offer but is protected by the option's irrevocability.^[1] For example, in a real estate scenario, a seller (optionor) may grant a buyer (optionee) a 30-day option to purchase property at a fixed price in exchange for a nominal payment, during which the seller cannot accept other bids or revoke the offer, allowing the buyer time to arrange financing.^[2]

Historical Origins

Option contracts trace their roots to English common law in the early 19th century, where courts began grappling with the enforceability of promises to keep offers open for acceptance. Initially, such promises were not binding without consideration, as illustrated by the landmark case Routledge v. Grant (1828), in which the court held that an offeror could revoke an offer at any time before acceptance, even if it included a stipulation to hold it open for a specified period, absent any bargained-for exchange.^[6] This decision underscored the common law's emphasis on revocability to protect offerors from indefinite commitments, limiting early recognition of options to those supported by nominal or substantial consideration, such as a paid premium, which transformed the promise into a enforceable contract.^[7] In the United States, these English principles were adopted and refined through judicial decisions and scholarly restatements, solidifying the option contract as an irrevocable offer backed by consideration. The Restatement (Second) of Contracts § 37 (1981), promulgated by the American Law Institute, formalized this by defining an option contract as a promise meeting general contract formation requirements that restricts the promisor's power to revoke the offer, thereby ensuring the offeree's power of acceptance persists despite events that would otherwise terminate it, such as rejection or the offeror's death. For commercial transactions involving the sale of goods, the Uniform Commercial Code (UCC) Article 2 introduced significant evolution in the mid-20th century; § 2-205 (1962) expanded enforceability by recognizing "firm offers" from merchants as irrevocable for up to three months without requiring consideration, provided they are in a signed writing giving assurance of firmness, addressing gaps in common law for modern business practices. Internationally, option-like mechanisms evolved differently in civil law traditions, with harmonization efforts bridging common and civil law approaches. In French civil law, the "pacte de préférence" under the Code Civil (as reformed in 2016, Article 1123) represents a precursor to options, obligating a party to offer priority negotiation or purchase rights to another before third parties, though traditionally distinguished from full options due to revocability concerns in pre-reform jurisprudence. The UNIDROIT Principles of International Commercial Contracts (first published 1994, Article 2.1.4) further advanced global recognition by treating options as irrevocable offers when supported by an explicit assurance or consideration, facilitating cross-border consistency without mandating consideration in all cases, reflecting ongoing efforts to reconcile divergent legal histories.

Formation and Requirements

Essential Elements

Financial options contracts are formed either through standardized exchange-traded mechanisms or customized over-the-counter (OTC) agreements, ensuring enforceability under regulatory frameworks rather than general common law principles.^[8]^[9] For exchange-traded options, the contract is created when a buyer's bid matches a seller's offer on a regulated exchange like the Chicago Board Options Exchange (CBOE) or CME Group, with terms predefined by the exchange to promote liquidity and reduce counterparty risk. Essential elements include the underlying asset (e.g., stock, index), strike price, expiration date, exercise style (American or European), and contract size (typically 100 units of the underlying).^[10]^[11] Once executed, the Options Clearing Corporation (OCC) acts as the guarantor, novating the trade to eliminate direct counterparty exposure.^[12] In OTC options, formation occurs via direct negotiation between parties, often institutional investors or dealers, resulting in bespoke terms documented in a confirmation or under a master agreement like the ISDA Master Agreement. Key elements mirror exchange-traded but are customizable, including non-standard strikes, expirations, or settlement methods, subject to regulatory reporting under Dodd-Frank Act provisions.^[13]^[14] Mutual intent is evidenced by the trade execution or signed confirmation, with definiteness ensured by clear specifications to avoid disputes; exchanges enforce standardization, while OTC relies on contractual clarity. Duration is fixed by the expiration date, beyond which the option lapses without value if unexercised.^[15] A representative example is purchasing a call option on Apple Inc. stock via an exchange: the buyer pays a premium for the right to buy 100 shares at a $200 strike price by January 2026 expiration; if the stock rises above $200, the option can be exercised or sold.^[8]

Consideration and Options

The primary consideration in financial options contracts is the premium paid by the buyer to the seller (writer), representing the market value of the right conveyed and determined by factors like underlying price, volatility, time to expiration, and interest rates.^[16] Unlike general contracts, nominal consideration is not applicable; the premium is substantial and non-refundable, serving as full payment for the option regardless of exercise.^[17] In exchange-traded options, the premium is exchanged at trade execution, with settlement through the clearinghouse on the next business day (T+1). For OTC, the premium is agreed upon negotiation and paid per contract terms, often upfront or at settlement. No separate bargained-for exchange beyond the premium is required for enforceability, as regulatory structures (e.g., SEC Rule 9b-1 for listed options) provide the binding framework.^[18]^[19] Promissory estoppel is rarely invoked due to the standardized and regulated nature, though in OTC disputes, courts may apply general contract principles if reliance is shown. Under U.S. commodities law (Commodity Exchange Act), certain firm commitments in futures-related options may not require additional consideration, but options themselves are premium-based.^[20] A notable aspect is the role of margin requirements: option sellers must post initial and maintenance margin to cover potential obligations, enforced by brokers and exchanges to mitigate risk, distinct from buyer premium payment. As of 2025, post-Dodd-Frank regulations mandate central clearing for certain standardized OTC options to enhance stability.^[21]^[22]

Applications

In Unilateral Contracts

Option contracts serve as a critical mechanism for integrating with unilateral contracts, where acceptance occurs solely through the offeree's performance rather than a promise. In such arrangements, the offeror makes a promise contingent on the offeree completing a specified act, but the offer remains revocable until performance begins. Upon the offeree tendering or commencing the invited performance, an implied option contract arises, preventing the offeror from revoking the offer for a reasonable time sufficient to complete the performance. This protects the offeree from investing effort only to have the offer withdrawn mid-performance.^[23] The Restatement (Second) of Contracts § 45 codifies this principle, stating that "where an offer invites an offeree to accept by rendering a performance," an option contract is created when the offeree begins that performance, thereby limiting the offeror's power to revoke. This implied option transforms the revocable unilateral offer into a binding commitment during the performance phase, ensuring the offeree can rely on the original terms. Without this safeguard, offerees might hesitate to act on open-ended promises due to revocation risks.^[24] A classic illustration is a newspaper advertisement offering a reward for the return of a lost dog, which constitutes a unilateral offer accepted only by the act of finding and returning the animal. If an offeree sees the ad and begins searching—such as by posting additional notices or canvassing neighborhoods—the offeror cannot then revoke the reward during that reasonable performance period, as the partial efforts create the implied option contract atop the unilateral offer. This example underscores how options maintain the integrity of reward-based unilateral promises in everyday scenarios. Legally, this integration overlays a bilateral element—the option contract—onto the unilateral framework, binding the offeror once the offeree provides consideration through the start of performance. The option enforces irrevocability, but full acceptance and the primary obligation to perform (and pay the reward) arise only upon completion. This dual structure balances the offeror's initial freedom with the offeree's need for security.^[1] The primary advantages of this approach lie in safeguarding the offeree's reliance during performance, encouraging actions that might otherwise be deterred by revocation fears. It is commonly applied in construction bids, where a contractor's initial site preparation after submitting a bid may invoke an option to prevent the owner from withdrawing the project mid-mobilization, and in employment incentives, such as performance-based bonuses that remain available once the employee begins the qualifying efforts. These uses promote efficiency in scenarios requiring substantial upfront investment by the offeree.^[25] However, limitations exist to prevent abuse: the option period must correspond to a reasonable time for completing the performance, as determined by the offer's terms and circumstances, and partial performance alone does not obligate the offeror to fulfill the promise without the full act or a formal option supported by separate consideration. Options in unilateral settings are often personal and non-assignable, tying protection to the specific offeree's efforts.^[23]

In Bilateral Agreements

In bilateral agreements, option contracts serve as embedded provisions that grant one party the right, but not the obligation, to exercise a future choice while both parties exchange mutual promises to form the underlying contract. These options secure strategic flexibility within reciprocal arrangements, such as a right of first refusal in partnership agreements, where one partner can match any third-party offer to acquire the other's interest before it is accepted.^[26] This integration allows parties to mitigate risks in ongoing relationships by preserving decision-making power without disrupting the bilateral exchange of obligations.^[27] Common applications include real estate leases with purchase options, enabling tenants to buy the property at a predetermined price after fulfilling lease terms, thereby combining rental commitments with potential ownership.^[28] In mergers and acquisitions, call options embedded in joint venture or shareholder agreements permit one party to compel the sale of shares at an agreed valuation, facilitating phased exits or control shifts amid uncertain market conditions.^[29] Supply contracts often incorporate options to extend terms, allowing buyers to renew delivery obligations based on future needs while sellers commit to availability.^[30] Such embedded options are enforceable as subsidiary bilateral promises, supported by the mutual consideration inherent in the overarching agreement, which eliminates the need for separate payment to bind the option.^[31] Breach of these provisions typically results in damages to compensate the non-breaching party for lost opportunities, though remedies may vary by jurisdiction and context.^[32] Unlike standalone option contracts, which function unilaterally and demand independent consideration to prevent revocation, embedded options derive their irrevocability and duration from the integrated bilateral terms, influencing available remedies and potentially limiting exercise periods to the contract's lifespan. For instance, in a joint venture agreement, one party might hold an option to buy out the other at an appraised value upon triggering events like dissolution, ensuring balanced control while upholding mutual investment promises.^[33]

Assignability and Transfer

General Principles

Option contracts confer a right on the optionee to accept an offer made by the optionor, and this right is generally assignable to a third party unless the option is personal in nature, such as one involving unique skills or services of the optionee.^[34]^[35] This default rule aligns with broader principles of contract law, as articulated in the Restatement (Second) of Contracts § 317, which permits the assignment of contractual rights except where substitution of the assignee would materially alter the optionor's duty, increase the burden or risk imposed on the optionor, or where the assigned right involves performance uniquely suited to the original optionee.^[35]^[36] The assignability distinction between benefits and burdens is central: the optionee may freely assign the benefit—the right to accept the offer and receive performance—while the optionor cannot delegate associated duties, such as maintaining the offer open, without the optionee's consent, as duties are not transferable absent agreement.^[34]^[37] Upon assignment, the assignee steps into the optionee's position to exercise the option, but the original optionee remains liable for any failure by the assignee to perform upon exercise, ensuring the optionor is protected from unfulfilled obligations.^[34] To effectuate the assignment and bind the optionor, the assignee must provide notice of the transfer to the optionor, after which the optionor deals directly with the assignee for exercise; without such notice, the optionor may validly perform to the original optionee.^[34]^[38] In commercial contexts involving the sale of goods, the Uniform Commercial Code § 2-210 further facilitates the assignability of option rights by deeming all rights assignable unless the assignment materially changes the other party's duty or burden, thereby promoting market liquidity and transferability in transactions like options to purchase inventory.^[39] For instance, if an optionee holds an option to buy a specified quantity of goods at a fixed price and assigns this right to another buyer, the assignee can exercise the option directly, subject to notifying the seller, allowing seamless transfer in dynamic commercial settings.^[39]^[40] A representative example occurs in real estate, where an optionee with the right to purchase a property at a predetermined price assigns that option to a new buyer; the assignee then notifies the seller (optionor) and exercises the right to acquire the property, transferring the benefit without altering the seller's underlying obligation to convey title upon payment.^[41] If the option involves personal services as consideration, such as an option tied to the optionee's expertise, assignability may be limited to preserve the personal character of the performance.^[34]

Restrictions and Exceptions

Option contracts, as assignable rights under general principles, face several restrictions and exceptions that limit or prohibit transfer to preserve the optionor's interests, public policy, or the contract's integrity. These limitations arise primarily from common law doctrines codified in the Restatement (Second) of Contracts § 317(2), which invalidates assignments that materially alter duties, violate statutes or policy, or contravene explicit contractual prohibitions. A key exception applies to option contracts involving personal services, where assignment is non-assignable if the underlying performance requires unique skills, discretion, or a relationship of personal trust and confidence. For instance, an option granting the right to employ a specific executive, such as a key inventor or leader whose expertise is integral to the venture, cannot be assigned without the optionor's consent, as substitution would undermine the expected personal performance. This rule protects the optionor from being bound to an assignee lacking the requisite qualities, as seen in broader personal services contract law where courts refuse enforcement to avoid involuntary servitude or mismatched obligations.^[42] Assignments are also prohibited if they materially change the optionor's duties, risks, or expected benefits, even in non-personal contexts. Under Restatement (Second) of Contracts § 317(2)(a), transferring an option to a financially unstable assignee, for example, could increase the optionor's exposure to default or litigation risks upon exercise, rendering the assignment invalid. Courts assess such changes based on the contract's original intent, voiding assignments that shift substantial burdens, such as altering payment terms or performance locations in a way that disadvantages the optionor. Explicit anti-assignment clauses in option contracts are generally enforceable, precluding transfer without consent, as they reflect the parties' bargained-for expectations. However, courts may invalidate such clauses if they impose unreasonable restraints on alienation, particularly in commercial contexts where free transferability promotes efficiency without harming the optionor.^[43] For example, a blanket prohibition on assigning an option to purchase standard goods might be voided if it lacks justification, balancing contractual freedom against public policy favoring assignability.^[44] Public policy further limits assignability in certain option contracts to prevent speculation, fraud, or undue government burden. Options embedded in government contracts are often non-assignable without explicit agency consent under the Anti-Assignment Act (41 U.S.C. § 6305), which prohibits transfers to safeguard fiscal accountability and performance standards. Similarly, options or rights to lottery prizes are statutorily non-assignable in many jurisdictions to curb gambling proliferation and ensure prizes benefit intended winners, as in California Government Code § 8880.325, which voids assignments except for limited payment transfers.^[45] These restrictions reflect broader policy against commodifying public entitlements.^[46]

Theoretical Framework

Role in Contract Theory

Option contracts play a central role in contract theory by exemplifying the bargain theory, which posits that enforceable obligations arise from mutual exchanges supported by consideration. Under the will theory of contracts, options enforce voluntary commitments by allowing parties to allocate risk and incentives through arm's-length bargaining, such as a seller granting a buyer the right to purchase at a fixed price for a premium, thereby promoting party autonomy and efficient resource use.^[47] This alignment underscores how options facilitate tailored agreements that reflect subjective intent and mutual benefit, distinct from mere gratuitous promises.^[47] However, relational contracting theory, as developed by Ian Macneil, critiques the rigidity of such discrete mechanisms like options in ongoing relationships, arguing that literal enforcement can undermine cooperation and mutual adjustment. Macneil emphasizes that contracts embed social norms and require good faith to preserve relational equilibrium, viewing unilateral options—such as termination clauses—as potentially opportunistic if they ignore contextual expectations in long-term deals.^[48] For instance, in scenarios where an option is exercised amid collaborative performance, rigid application may conflict with the contract's broader purpose of sustaining trust.^[48] From an economic perspective, option contracts enhance efficiency by reducing transaction costs through clear commitments that lock in rights and deter hold-up problems, aligning with the Coase theorem's principle that well-defined property rights enable parties to bargain toward optimal outcomes absent frictions. By temporarily assigning decision rights, options minimize renegotiation expenses in uncertain environments, promoting Pareto improvements in resource allocation.^[47]^[49] The Williston-Corbin debate highlights tensions in option enforceability: Samuel Williston advocated strict consideration to ensure genuine bargains, treating options without it as unenforceable to prevent illusory promises, while Arthur Corbin favored interpretive flexibility based on commercial intent, prioritizing certainty in business transactions even with nominal consideration.^[50] This evolution reflects a broader theoretical shift from 19th-century laissez-faire emphasis on absolute freedom and formalities to 20th-century protections for reliance, where options increasingly support equitable enforcement beyond rigid exchange requirements.^[51] In civilian systems, options reinforce pacta sunt servanda—the binding force of agreements—while good faith principles overlay to mitigate abuse, as seen in codes requiring loyal performance.^[52]

Relation to Promissory Estoppel

Promissory estoppel and option contracts share doctrinal overlap in addressing the irrevocability of promises or offers, particularly where enforcement is sought without traditional consideration, but they operate through distinct mechanisms. Promissory estoppel, as articulated in Restatement (Second) of Contracts § 90, enforces a promise that induces reasonable and foreseeable detrimental reliance by the promisee, aiming to prevent injustice from such reliance.^[53] A seminal illustration is Hoffman v. Red Owl Stores, Inc., where the Wisconsin Supreme Court applied promissory estoppel to enforce representations made during franchise negotiations, awarding reliance damages after the plaintiff quit his job and sold assets in reliance on the defendant's assurances of a dealership opportunity.^[54] In contrast, option contracts achieve stricter irrevocability through bargained-for consideration, defined in Restatement (Second) of Contracts § 25 as a promise that limits the promisor's power to revoke an offer, creating a binding contractual right to accept within a specified period.^[55] Promissory estoppel often supplements option contracts in scenarios where consideration is absent or inadequate, such as gratuitous promises to hold an offer open that prompt reliance. Under Restatement (Second) of Contracts § 87(2), an offer becomes binding as an option contract if the offeror reasonably expects it to induce substantial action or forbearance by the offeree before acceptance, and such reliance occurs, even without meeting the writing or consideration requirements of § 87(1).^[56] Courts have invoked this to imply options via estoppel; for instance, in Berryman v. Kmoch, the Oregon Supreme Court enforced an oral option agreement for farmland purchase under promissory estoppel after the offeree incurred expenses in preparation, despite lacking nominal consideration.^[57] This application treats the reliance as a functional equivalent to consideration, bridging gaps in informal arrangements. Key differences underscore their divergent foundations: option contracts are proactive and contractual, establishing full expectation interests through mutual assent and consideration (or its statutory substitutes), whereas promissory estoppel is reactive and equitable, providing only remedial relief focused on compensating for reliance losses to avert unconscionable harm.^[58] Unlike options, which grant the offeree a vested right to form a bilateral contract upon exercise, estoppel merely estops revocation to the extent necessary for justice, often limiting recovery to out-of-pocket expenses rather than full performance value.^[59] In modern contract law, convergence between the doctrines appears in frameworks like the Uniform Commercial Code (UCC) and Restatement provisions governing firm offers. UCC § 2-205 renders a merchant's signed writing assuring an offer will be held open irrevocable for the stated time (up to three months) without consideration, effectively blending option-like irrevocability with estoppel's reliance rationale to facilitate commercial certainty.^[60] The Restatement (Second) of Contracts § 87 further integrates estoppel by recognizing reliance-based options, filling gaps in informal or non-commercial settings where strict consideration rules might otherwise invalidate promises.^[56] Despite these overlaps, limitations persist: promissory estoppel does not fully replicate an option contract, as it only restricts revocation based on actual reliance rather than creating an independent contractual obligation, and remedies remain discretionary and reliance-oriented.^[58] It serves as no substitute in formal commercial contexts governed by UCC firm offer rules or where parties intend a bargained-for exchange, and some courts decline to extend it to preempt revocation absent substantial detriment.^[61]

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Jul 17, 2025 · In domestic law, it governs the sanctity of contracts and requires parties to perform their contractual obligations in good faith, unless there ...
[50]
Restatement Second of Contracts § 90 (Promissory Estoppel) | H2O
A promise which the promisor should reasonably expect to induce action or forbearance on the part of the promisee or a third person and which does induce such ...
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Hoffman v. Red Owl Stores, Inc. :: 1965 - Justia Law
Promissory estoppel is a doctrine that may be applied when a party reasonable relies upon a promise and injustice would result from failing to enforce it, ...
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Restatement (2d) 25, 45 and 87 -- Option Contracts - Open Casebooks
An option contract is a promise which meets the requirements for the formation of a contract and limits the promisor's power to revoke an offer. Restatement ( ...
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Note (Restatement Second Contracts § 87) | H2O - Open Casebooks
(1) An offer is binding as an option contract if it · (a) is in writing and signed by the offeror, recites a purported consideration for the making of the offer, ...
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Contracts: : Berryman v. Kmoch, 559 P. 2d 790 (1977) | H2O
We turn next to appellant's contention that the option contract should have been enforceable under the doctrine of promissory estoppel. This doctrine has ...
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Promissory Estoppel as a Substitute for Consideration
In contract law, promissory estoppel is an exception to the requirement of consideration for a contract to be enforceable.
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[PDF] Section 90 as Catch-22
The decisions suggest that most commercial actors consider promissory estoppel liability as a risk to be avoided rather than as a valuable opportunity to create ...
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§ 2-205. Firm Offers. | Uniform Commercial Code - Law.Cornell.Edu
An offer by a merchant to buy or sell goods in a signed writing which by its terms gives assurance that it will be held open is not revocable.
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[PDF] Firm Offers Under the UCC and the CISG - Insight @ Dickinson Law
Oct 1, 2000 · In this article, the term "option contract" refers to the contract formed when consideration is exchanged for a promise not to revoke an offer.