Option contract

Option contract

Options contracts are complex financial instruments and are not suitable for all investors. Before entering into an options contract, it is important to understand the risks and rewards involved. 

What is an options contract? 

An options contract is a two-party agreement, the buyer and the seller, to buy or sell an asset at a specified price, known as the strike price, on or before a specific date, known as the expiration date. There are two types of options: call options and put options.  

Options are traded on exchanges such as the New York Stock Exchange and the Chicago Board Options Exchange. The value of an option contract is based on the underlying asset’s price, with the price rising and falling as the price of the asset changes.  

Options contracts are typically bought and sold by investors speculating on the underlying asset’s future price. For example, if an investor believes that the price of gold will increase, they might buy a gold call option. If the price of gold increases, the investor will profit from their investment.  

Types of an option contract 

Puts and calls are the two different types of options contracts. Both can be bought to reduce risk or speculatively predict the security’s direction. They may also be sold to make money. 

  • Put options contract 

Put options can assist you in making money if your prediction of how a stock will move is accurate. A put option is a contract that grants the holder the option, but not the obligation, to sell a certain underlying asset at a fixed price, often known as the strike price, within a predetermined time frame (the “expiration”). 

Before or at expiry, if the share price declines below the striking price, the buyer has two options: allocate shares to the seller for acquisition at the strike price, or sell the contract if the assets are not held in a portfolio. 

  • Call options contract 

Financial contracts known as call options provide the option buyer with the right, but not the duty, to purchase a stock, commodity, bond or any other instrument or asset at a particular price within a predetermined time frame. The underlying asset is a stock, bond, or product. When the underlying asset’s value rises, the call buyer makes money. 

Features of an option contract 

  • Options contracts can be used to hedge against risk. For example, if a stockholder is worried that the price of a stock they own might fall, they could buy a put option. If there is a fall in the stock price, the put option will increase in value, offsetting some of the stockholder’s losses.  
  • Because options contracts receive their values from the market behavior of the underlying asset, they are considered derivatives. 
  • Option contracts are contracts having a deadline. The option expires if the holder does not exercise it on or before a specific date. 
  • Investors utilise options such as hedging to lower the risk associated with other open holdings by taking an opposing position in the markets.  

How option contract work 

An option contract is a financial contract that gives the holder the right, but not the obligation, to sell or buy an underlying asset at a specified price within a specified period. The underlying asset can be a security, such as a stock or bond, or a commodity, such as oil or gold.  

An option contract’s terms outline the underlying securities, the strike price at which it can be traded, and the contract’s expiration date. A conventional stock contract covers 100 shares; however, the share quantity may change for special dividends, stock splits, or mergers. 

Call options may often be bought as a leveraged bet on an index or stock’s growth. Conversely, you often buy put options to benefit when prices fall. 

Example of an options contract 

The share price of XYZ company is US$ 80, and a call writer wants to sell calls having a one-month expiration of 85 US$. The call writer maintains the shares and is still eligible to get an additional premium by writing new calls if the share price remains below US$85 after the options expire. 

However, if the share price rises to over US$85, known as being in-the-money (ITM), the purchaser contacts the seller and buys the shares for US$85, if buying the shares is not the intended outcome, the call-buyer also can sell the options. 

Frequently Asked Questions

A few advantages of an options contract are: 

  • They can offer better cost-effectiveness. 
  • They can be less dangerous than stocks. 
  • They might result in a larger percentage of returns. 
  • They provide a variety of tactical options. 

A few disadvantages of an options contract are: 

  • Due to their decreased liquidity, some stock options are exceedingly challenging for traders to enter and exit. 
  • Trading options is more costly than trading futures or stocks. Discount brokers do, however, occasionally provide traders with the chance to trade with lesser commissions. However, most full-service brokers have higher commission rates for trading options. 
  • The worst thing about trading options is time decay. No matter how the underlying behaves, the worth of your option premium drops by a certain amount every day. 
  • What are the drivers of the option contract value? 

These factors influence options price: 

  • The underlying cost 
  • The strike value. 
  • The expiration period. 
  • Type of options 
  • Dividends 
  • Interest rate 
  • Volatility 

A put or call option’s strike price determines the cost at which it can be executed. It is often referred to as exercise price. One of the two crucial choices a trader or investor must make when choosing an option is the strike price and the period to expiry. 

The pricing of an option contract on the open market is called an option premium. Hence, it refers to the money the seller of an option contract receives from the opposing party. Extrinsic and intrinsic value comprise the two components of in-the-money option premiums.  

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