An options contract represents an agreement between two parties to potentially transact on an underlying asset, like a stock, at a set price, known as the strike price, either before or on a specified expiration date.
Key Insights
- Options contracts facilitate potential transactions involving an asset at agreed-upon prices and dates.
- Calls are used for betting on an asset’s value increase, while puts are for anticipating declines.
- Purchasing an option provides the right—but not the obligation—to buy or sell the underlying asset.
- Typically, one stock options contract covers 100 shares of the underlying stock.
Grasping the Concept of Options Contracts
Options are financial tools based on the value of underlying securities, such as stocks. An options contract gives its buyer the ability to buy or sell, depending on the type of option, the chosen asset at the contract-specified price and within the contract’s timeframe or by its expiration date.
American options allow exercise any time before expiration, whereas European options can only be exercised on the expiration date.
An options contract will outline the underlying security, the transaction price, and the expiration. For stocks, a standard agreement usually covers 100 shares, though this can change due to events like stock splits or mergers.
Options can be used for both hedging risk or for speculation. They are typically cheaper than the underlying stock because they utilize a form of leverage, allowing investors to make market bets without directly purchasing shares. The party buying the options pays a premium for these rights.
Types of Options Contracts
Call Option Contract
Buying a call option lets the investor purchase the underlying asset at the strike price within a certain period. Sellers, who receive a premium, must provide shares at the agreed price if the buyer chooses to exercise the option. Those possessing the shares protectively are covering the call.
Put Option Contract
Put buyers are betting the stock price will decrease. They hold rights to sell at the designated strike price before expiration. If the market price goes below the strike, they may sell shares to the strike price, or resell the put option if they don’t own the stocks.
Practical Example of an Options Contract
Imagine shares of Company ABC are priced at $60. A call seller looks to sell calls at a $65 strike price with a one-month expiration. If ABC’s share price remains below $65 at expiration, the option writer retains both the shares and the premium. They can repeat this process.
However, if ABC’s shares exceed $65, the option is ‘in-the-money’ (ITM). The buyer can call the shares, buying them at $65, or sell the option for profit if purchasing the shares isn’t the aim.
Related Terms: call options, put options, strike price, underlying security.
References
Get ready to put your knowledge to the test with this intriguing quiz!
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## What is an options contract?
- [ ] An agreement to directly buy and sell real estate
- [ ] A bond issued by a corporation
- [x] A financial derivative that gives the right, but not the obligation, to buy or sell an asset at a predetermined price
- [ ] An insurance policy for financial losses
## What does the "strike price" mean in an options contract?
- [x] The predetermined price at which the holder can buy or sell the underlying asset
- [ ] The current market price of the underlying asset
- [ ] The fee paid to purchase the option
- [ ] The difference between the market price and the exercise price
## What is a "call option"?
- [x] An option contract giving the holder the right to buy a certain amount of the underlying asset
- [ ] An option contract giving the holder the right to sell a certain amount of the underlying asset
- [ ] A type of derivative based on commodity prices
- [ ] An agreement to lend money at a future date
## What is a "put option"?
- [ ] An option contract giving the holder the right to buy a certain amount of the underlying asset
- [x] An option contract giving the holder the right to sell a certain amount of the underlying asset
- [ ] A request to withdraw money from an account
- [ ] A long-term investment option
## What does it mean for an option to be "in the money"?
- [x] The exercise price is favorable compared to the current market price
- [ ] The option is very cheap to purchase
- [ ] The seller has made a profit
- [ ] The cost of the option is higher than the strike price
## Who are the primary participants in the options market?
- [ ] Currency exchange auditors
- [ ] Real estate agents and appraisers
- [x] Options holders and writers
- [ ] Insurance brokers
## What is "premium" in the context of options contracts?
- [ ] The interest rate of an associated loan
- [x] The price paid for purchasing the option
- [ ] The amount of dividends received from holding an option
- [ ] The commission fee for trading the option
## When does an option typically expire?
- [ ] It has no expiration date
- [x] On a pre-determined date, usually specified in the contract
- [ ] At the discretion of the current holder
- [ ] When the market for the underlying asset is closed
## What is the primary difference between American and European options?
- [ ] American options can only be traded on U.S. soil
- [x] American options can be exercised anytime before the expiration date, while European options can only be exercised on the expiration date
- [ ] European options have a higher premium than American options
- [ ] European options are traded on the European market only
## What does "writing an option" mean?
- [ ] Creating new stock for a company
- [ ] Scribbling down trading strategies
- [x] Selling an option contract to another investor
- [ ] Developing a financial report
