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.  

Related Terms

    Read the Latest Market Journal

    How to soar higher with Positive Carry!

    Published on Mar 28, 2024

    As US Fed interest rates are predicted to rise 6 times this year, it’s best...

    Why 2024 Offers A Small Window of Opportunity and How to Position Yourself to Capture It

    Published on Mar 28, 2024 17 

    With the Federal Reserve (FED) finally indicating rate cuts in 2024, we witnessed a significant...

    Weekly Updates 25/3/24 – 29/3/24

    Published on Mar 25, 2024 47 

    This weekly update is designed to help you stay informed and relate economic and company...

    Weekly Updates 18/3/24 – 22/3/24

    Published on Mar 18, 2024 62 

    This weekly update is designed to help you stay informed and relate economic and company...

    The Rise of AI – Top traded AI counters in February 2024

    Published on Mar 18, 2024 478 

    Start trading on POEMS! Open a free account here! At a glance: Record highs for...

    Playing Defence: Diversification in Forex Trading

    Published on Mar 15, 2024 66 

    Introduction In our ever-evolving financial world, Forex trading has emerged as a popular trading vehicle...

    Demystifying Forex Trading – Technical Analysis

    Published on Mar 12, 2024 93 

    In the world of financial markets, the Forex market stands out as the largest, most...

    Demystifying Forex Trading: Fundamental Analysis

    Published on Mar 11, 2024 63 

    In the world of financial markets, the Forex market stands out as the largest, most...

    Contact us to Open an Account

    Need Assistance? Share your Details and we’ll get back to you

    IMPORTANT INFORMATION

    This material is provided by Phillip Capital Management (S) Ltd (“PCM”) for general information only and does not constitute a recommendation, an offer to sell, or a solicitation of any offer to invest in any of the exchange-traded fund (“ETF”) or the unit trust (“Products”) mentioned herein. It does not have any regard to your specific investment objectives, financial situation and any of your particular needs. You should read the Prospectus and the accompanying Product Highlights Sheet (“PHS”) for key features, key risks and other important information of the Products and obtain advice from a financial adviser (“FA“) pursuant to a separate engagement before making a commitment to invest in the Products. In the event that you choose not to obtain advice from a FA, you should assess whether the Products are suitable for you before proceeding to invest. A copy of the Prospectus and PHS are available from PCM, any of its Participating Dealers (“PDs“) for the ETF, or any of its authorised distributors for the unit trust managed by PCM.  

    An ETF is not like a typical unit trust as the units of the ETF (the “Units“) are to be listed and traded like any share on the Singapore Exchange Securities Trading Limited (“SGX-ST”). Listing on the SGX-ST does not guarantee a liquid market for the Units which may be traded at prices above or below its NAV or may be suspended or delisted. Investors may buy or sell the Units on SGX-ST when it is listed. Investors cannot create or redeem Units directly with PCM and have no rights to request PCM to redeem or purchase their Units. Creation and redemption of Units are through PDs if investors are clients of the PDs, who have no obligation to agree to create or redeem Units on behalf of any investor and may impose terms and conditions in connection with such creation or redemption orders. Please refer to the Prospectus of the ETF for more details.  

    Investments are subject to investment risks including the possible loss of the principal amount invested. The purchase of a unit in a fund is not the same as placing your money on deposit with a bank or deposit-taking company. There is no guarantee as to the amount of capital invested or return received. The value of the units and the income accruing to the units may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the Products. There can be no assurance that investment objectives will be achieved.  

    Where applicable, fund(s) may invest in financial derivatives and/or participate in securities lending and repurchase transactions for the purpose of hedging and/or efficient portfolio management, subject to the relevant regulatory requirements. PCM reserves the discretion to determine if currency exposure should be hedged actively, passively or not at all, in the best interest of the Products.  

    The regular dividend distributions, out of either income and/or capital, are not guaranteed and subject to PCM’s discretion. Past payout yields and payments do not represent future payout yields and payments. Such dividend distributions will reduce the available capital for reinvestment and may result in an immediate decrease in the net asset value (“NAV”) of the Products. Please refer to <www.phillipfunds.com> for more information in relation to the dividend distributions.  

    The information provided herein may be obtained or compiled from public and/or third party sources that PCM has no reason to believe are unreliable. Any opinion or view herein is an expression of belief of the individual author or the indicated source (as applicable) only. PCM makes no representation or warranty that such information is accurate, complete, verified or should be relied upon as such. The information does not constitute, and should not be used as a substitute for tax, legal or investment advice.  

    The information herein are not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject PCM to any registration or licensing requirement in such jurisdiction or country. The Products is not offered to U.S. Persons. PhillipCapital Group of Companies, including PCM, their affiliates and/or their officers, directors and/or employees may own or have positions in the Products. Any member of the PhillipCapital Group of Companies may have acted upon or used the information, analyses and opinions herein before they have been published. 

    This advertisement has not been reviewed by the Monetary Authority of Singapore.  

     

    Phillip Capital Management (S) Ltd (Co. Reg. No. 199905233W)  
    250 North Bridge Road #06-00, Raffles City Tower ,Singapore 179101 
    Tel: (65) 6230 8133 Fax: (65) 65383066 www.phillipfunds.com