An options contract represents an agreement between two parties to facilitate a potential transaction involving an asset at a preset price and date, also known as the strike price. This contract allows one to strategize investments, offering the flexibility to buy or sell an asset within a specified period before or on the expiration date.
Key Takeaways
- An options contract is an agreement designed to enable a potential transaction on an asset at a pre-determined price and date.
- Call options offer leverage to profit from asset appreciation, whereas put options are aimed at gains from price declines.
- Purchasing an option provides the holder the right, but not the obligation, to buy or sell the underlying asset.
- A single stock option contract typically covers 100 shares of the underlying stock.
Diving Deeper into Options Contracts
Options are financial tools that derive their value from underlying securities like stocks. They offer buyers the choice to buy or sell the stipulated underlying asset at a price stated in the contract, either within a particular timeframe or at the expiration date.
American options can be exercised at any point before the expiration date, while European options are only exercisable on the expiration date itself.
The terms within an options contract specify key details such as the underlying security, the strike price, and the expiration date. Standard contracts for stocks typically encompass 100 shares, although adjustments may occur following stock splits, special dividends, or mergers.
Options are popularly used for hedging purposes but also lend themselves to speculative investments. They’re generally much cheaper than the underlying shares, enabling investors to leverage their positions to bet on stock movements without outright purchasing the shares. This potentiality comes with a premium that options buyers must pay to the seller.
Types of Options Contracts: Exploring Calls and Puts
Two primary forms of options contracts exist: puts and calls. Both serve the purpose of speculation on security movements or to hedge investments, and can also be sold to generate income.
In general, call options are leveraged bets on the appreciation of a stock or index, while put options are acquired to benefit from price declines. Buyers of call options have the right, though not the obligation, to buy shares at the strike price, whereas put buyers can sell at the strike price defined in the contract.
Option sellers, often known as writers, are committed to execute the transaction if the purchaser opts to enact a call or put option.
- Call Option Contract : Within a call option, the contracts are bought from sellers, who receive a premium to bear the responsibility of selling shares at the strike price when called upon. If the seller also holds the corresponding shares, this is known as a covered call.
- Put Option Contract : Put option buyers speculate on decreases in the price of a stock or index. They hold the right to sell the shares at the contract’s strike price. Should the stock price fall beneath this price before or at expiration, they may either assign shares to the seller or sell the contract.
A Practical Example of an Options Contract
Imagine Company XYZ’s shares are trading at $60. A call writer opts to sell calls at a strike price of $65, with an expiration in one month. If the share price remains below $65, the options expire and the call writer retains the shares while potentially writing new calls for another premium.
However, if the share price rises above $65 – a scenario known as being in-the-money (ITM) – the buyer of the call may purchase the shares at $65 or alternatively sell the option if acquiring the shares is not desired.
Related Terms: financial instruments, underlying security, strike price, expiration date.
