Options Contract: What It Is, How It Works, Types of Contracts

What Is an Options Contract?

An options contract is an agreement between two parties to facilitate a potential transaction on an underlying security at a preset price, referred to as the strike price, prior to or on the expiration date.

Understanding an Options Contract

Options are financial instruments that are based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the chosen underlying asset at a price set out in the contract either within a certain timeframe or at the expiration date.

The terms of an option contract specify the underlying security, the price at which that security can be transacted (strike price), and the expiration date of the contract. In the case of stocks, a standard contract covers 100 shares, but the share amount may be adjusted for stock splits, special dividends, or mergers.

Options are generally used for hedging purposes but can be used for speculation, too. Options generally cost a fraction of what the underlying shares would. Using options is a form of leverage, allowing an investor to make a bet on a stock without having to purchase or sell the shares outright. In exchange for this privilege, the options buyer pays a premium to the party selling the option.

Types of Options Contract

There are two types of options contract: puts and calls. Both can be purchased to speculate on the direction of the security or hedge exposure. They can also be sold to generate income.

In general, call options can be purchased as a leveraged bet on the appreciation of a stock or index, while put options are purchased to profit from price declines. The buyer of a call option has the right, but not the obligation, to buy the number of shares covered in the contract at the strike price. Put buyers, on the other hand, have the right, but not the obligation, to sell the shares at the strike price specified in the contract.

Option sellers, also known as writers, are obligated to transact their side of the trade if a buyer decides to execute a call option to buy the underlying security or execute a put option to sell.

• Call Option Contract: In a call option transaction, a position is opened when a contract or contracts are purchased from the seller. In the transaction, the seller is paid a premium to assume the obligation of selling shares at the strike price. If the seller holds the shares to be sold, the position is referred to as a covered call.
• Put Option Contract: Buyers of put options are speculating on price declines of the underlying stock or index and own the right to sell the shares at the strike price specified in the contract. If the share price drops below the strike price prior to or at expiration, the buyer can either assign shares to the seller for purchase at the strike price or sell the contract if the shares are not held in the portfolio.
  

Example of an Options Contract

Company ABC's shares trade at $60, and a call writer is looking to sell calls at $65 with a one-month expiration. If the share price stays below $65 and the options expire, the call writer keeps the shares and can collect another premium by writing calls again.

If, however, the share price appreciates to a price above $65, referred to as being in-the-money (ITM), the buyer calls the shares from the seller, purchasing them at $65. The call-buyer can also sell the options if purchasing the shares is not the desired outcome.