What Is an Options Contract ?
Options contracts are agreements between a buyer and seller which give the buyer the right to buy or sell a particular asset at a later date (expiration date) and an agreed-upon price (strike price).
They’re often used for securities, commodities, and real estate transactions. In other words, buyers can purchase them much like other types of assets within brokerage accounts.
What Are Call & Put Options?
There are two types of option contracts: put and call options. Both types help investors earn a profit based on how they think the underlying asset will fare in the market within a predetermined amount of time.
Call and put options are discussed in greater detail below.
How Does an Options Contract Work?
An options contract has terms that specify the strike price, the underlying security, and expiration date. Typically, a contract will cover 100 shares (though it can be adjusted for special dividends, mergers, or stock splits).
When agreeing on an options contract, buyers need to look at the “ask” price (the amount a seller is willing to receive). When you offer to buy into an options contract, you’ll offer a “bid” price, which is always lower than the ask price.
Once a contract is purchased from a seller or writer, a position is opened and the seller is paid to sell (buy) an asset at the agreed upon strike price – if the buyer chooses to execute the options contract. Buyers have the right to buy (sell) an asset at the strike price but aren't obligated to.
Features of Option Contracts
There are standardized contracts which buyers can purchase through the exchanges – they’re settled through a clearing house and the options contract settlement is guaranteed. Buyers can purchase stock options, commodity options, bond and interest rate options, index options, and futures options.
Aside from standard features – such as the amount of an asset, the type of options contract, the underlying instrument, and the strike price – there’s also the option price (premium). This amount varies.
Over-the-Counter Option Contracts
Over–the-counter option contracts are also available. These are trades between two private parties and may include interest rate options, currency exchange rate options, and swaps (such as trading long- and short-term interest rates). Since they're private transactions, expiration dates and strike prices aren't standardized.
Option Contract Example
Let’s use a simple call option contract to illustrate how it works.
You expect Company XYZ's stock price to go up to $90 within the next month. You find out that you can buy an option contract for this company at $4.50 with a strike price of $75 per share. That means you’ll pay $450 for your options contract ($4.50 x 100 shares).
The stock price begins to rise as you expect and stabilizes at $100. Prior to the expiry date on the options contract, you execute the call option and buy all 100 shares of Company XYZ at $75 (the strike price) for $7,500.
Since it’s worth $100 a share, you can then sell your new stock on the market for $10,000. Your profit would be $2,050, since you’d need to take the original $450 options contract into account ($10,000 - $7,500 - $450 = $2,050).
Calls & Puts: Option Contract Variations
The two main types of options are calls and puts.
Call Options Contracts
Call options contracts are for investors who want the right to purchase an asset at the strike price. The buyer needs to pay the premium up front when entering the contract. As long as the market moves in the buyer’s favor, they can take advantage of the potential profit. Buyers purchase calls when they think the price of a specific asset will go up, and sell if they believe it’ll decrease.
If the spot price (the current value of the asset) doesn’t go over the strike price before the contract expires, the buyer loses the money they paid. When the asset price exceeds the strike price, the buyer makes a profit.
If the spot price is higher than the strike price when the option expires, the seller will incur a loss that’s equivalent to the buyer’s profit. If the spot price is lower than the strike price, then the option will expire worthless. The seller can then earn a profit based on the premium the buyer paid.
Put Option Contracts
Put options contracts let the buyer sell an asset at the agreed-upon strike price (as stated in a contract). The risk lies in the premium paid but the potential for profit can be high (since it depends on the difference between the asset price and the strike price). That means if the spot price is lower than the strike price, the contract will be executed and the buyer is considered “in the money.” If not, the contract will expire and the seller will pocket the premium paid.
For sellers, the potential for profit is the premium the buyer paid. Since they’re bound by an obligation to buy the asset at the strike price, their potential loss can be high.
What Happens When Options Contracts Expires?
Every options contract will have a specific expiration date. That means the value of the contract relies heavily on the date. You can choose to buy, sell or exercise the contract within this timeframe. However, when an options contract expires, the contract is no longer valid.
Options Contract vs. Future Contract
Both options and futures contracts are products designed to make investors money or to hedge current investments. Both give an opportunity for the buyer to purchase an asset by a specific date at a specific price.
An options contract gives the buyer the right to sell or purchase shares, whereas, with a futures contract, investors are required to purchase or sell shares on a specific date in the future (unless a holder’s position is closed before the expiration date).