What it is:
How it works (Example):
There are several types of options contracts in financial transactions. An exchange traded option, for example, is a standardized contract that is settled through a clearing house and is guaranteed. These exchange traded options cover stock options, commodity options, bond and interest rate options, index options, and futures options. Another type of option contract is an over –the-counter option which is a trade between two private parties. This may include interest rate options, currency exchange rate options, and swaps (i.e. trading long and short terms interest rates).
The main features of an exchange traded option, such as a call options contract, provides a right to buy 100 shares of a security at a given price by a set date. The options contract charges a market-based fee (called a premium). The stock price listed in the contract is called the "strike price. At the same time, a put options contract gives the buyer of the contract the right to sell the stock at a strike price by a specified date. In both cases, if the buyer of the options contract does not act by the designated date, the option expires.
For example, in a simple call options contract, a trader may expect Company XYZ's stock price to go up to $90 in the next month. The trader sees that he can buy an options contract of Company XYZ at $4.50 with a strike price of $75 per share. The trader must pay the cost of the option ($4.50 X 100 shares = $450). The stock price begins to rise as expected and stabilizes at $100. Prior to the expiry date on the options contract, the trader executes the call option and buys the 100 shares of Company XYZ at $75, the strike price on his options contract. He pays $7,500 for the stock. The trader can then sell his new stock on the market for $10,000, making a $2,050 profit ($2,500 minus $450 for the options contract).
Why it Matters:
Options contracts are an important tool which give traders the opportunity to hedge their stock positions. Options allow for a leveraged position on a stock, while mitigating the risk of the full purchase. Similarly, in real estate, an options contract may permit a buyer to secure options contracts on multiple parcels before having to execute the purchase on any single one, ensuring that the buyer will be able to assemble them all before moving ahead.