What is An Options Contract: A Complete Guide for Beginners

Views 255Apr 26, 2024

Options contracts offer a unique way for investors to participate in financial markets. Unlike traditional stock trading, options provide the buyer the right, but not the obligation, to buy or sell an asset (depending on the option), at a set price within a specified timeframe.

This flexibility can be advantageous for some investors, as it allows for potential profits from market movements while helping to limit some downside risks. Understanding the basics of options contracts is essential for investors looking to diversify their portfolios and navigate the complexities of the financial markets.

What are options contracts?

Options contracts can cover various types of assets including stocks, commodities, currencies, and indexes. These contracts provide flexibility for investors to speculate on price movements in the underlying asset without actually owning it.

Common types of assets that options contracts may cover include:

Stocks: Options contracts can be based on individual stocks, allowing investors to speculate on the price movements of specific companies.
Indexes: Options contracts can also be linked to stock market indexes such as the S&P 500 or the Dow Jones Industrial Average, providing exposure to broad market trends.
Exchange-Traded Funds (ETFs): Options contracts may be based on ETFs, which are investment funds that hold assets such as stocks, bonds, or commodities and trade on stock exchanges.
Commodities: Options contracts can be tied to commodities such as gold, oil, or agricultural products, allowing investors to hedge against price fluctuations in these markets.
Currencies: Options contracts may cover foreign exchange rates, enabling investors to speculate on currency movements between different countries.
Interest Rates: Options contracts can be linked to interest rates, providing a way for investors to hedge against changes in borrowing costs or to speculate on future interest rate movements.

How do options contracts work?

Options contracts include key elements such as the expiration date, strike price, the underlying asset, and the option type. The expiration date determines when the contract expires, while the strike price is the predetermined price at which the underlying asset can be bought or sold. The underlying asset is the security that the option in part derives its value from, and the option type specifies whether it is a call or put option.

Disclaimer: The data involved in the picture is fictitious and the cost does not include commission and other fees.

Two types of options contracts

Call options contract: A call option gives the buyer the right, but not the obligation, to purchase the underlying asset at the strike price before the expiration date.

Buy side: Let's say you purchase a call option contract for Company X with a strike price of $50 and a premium of $2 per contract. If the stock price rises above $52 ($50 strike price + $2 premium) before the expiration date, you can exercise the option to buy shares at $50 and sell them at the market price, potentially earning a profit.
Sell side: As a call option seller, you receive the premium upfront. If the underlying stock price is below the strike price, the option expires worthless, and you keep the premium. However, if the stock price rises upon expiration, you may be obligated to sell shares at the strike price, potentially limiting your gains or incurring a loss.

Put options contract: A put option gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price before the expiration date.

Buy side: Suppose you purchase a put option contract for Company Y with a strike price of $100 and a premium of $3 per share. If the stock price falls below $97 ($100 strike price - $3 premium) before the expiration date, you can exercise the option to sell shares at $100.
Sell side: As a seller of a put option, you receive the premium upfront. If the option expires worthless, you keep the premium. However, if the stock price falls, you may be obligated to buy shares at the strike price, potentially incurring losses; the stock could fall and yet you could still make a profit breakeven but if it fell 'significantly' it would be unlikely. This depends upon what the original spread was (distance between strike price and time of option purchase/sale in relation to how much the stock falls).

Potential advantages and disadvantages of calls and puts

Calls and puts can offer distinct advantages and disadvantages for investors. For buyers, calls provide potential for unlimited gains with limited risk while puts allow them to potentially profit from declining prices of the underlying stock. However, both options involve the risk of losing the entire premium paid for the contract.

Call options contract

	Advantages	Disadvantages
Buyer Side	Buying a call option allows investors to potentially profit from upward price movements in the underlying asset while limiting risk to the premium paid. It offers the opportunity for significant gains with a smaller initial investment compared to buying the asset outright.	The main risk for call buyers is the potential loss of the premium paid if the underlying asset's price does not rise above the strike price before expiration.
Seller Side	Selling a call option generates immediate income in the form of the premium received. If the underlying asset's price remains below the strike price, the seller keeps the premium without further obligation.	The seller of a call option faces the risk of significant losses if the underlying asset's price rises above the strike price, as they may be obligated to sell the asset at a lower price than the market value.

Put options contract - Potential Advantages

	Advantages	Disadvantages
Buyer Side	Buying a put option allows investors to potentially profit from downward price movements in the underlying asset while limiting risk to the premium paid. It offers a form of insurance against potential losses in a portfolio or specific asset.	The main risk for put buyers is the potential loss of the premium paid if the underlying asset's price does not fall below the strike price before expiration.
Seller Side	Selling a put option generates immediate income in the form of the premium received. If the underlying asset's price remains above the strike price, the seller keeps the premium without further obligation.	The seller of a put option faces the risk of significant losses if the underlying asset's price falls below the strike price, as they may be obligated to buy the asset at a higher price than the market value.

What is an option's premium?

An option's premium represents the current market price of the option contract. It consists of two main components: intrinsic value and time value.

Intrinsic Value: This is the difference between the current price of the underlying asset and the option's strike price. For call options, the intrinsic value is the market price of the asset minus the strike price (if positive). For put options, it is the strike price minus the market price of the asset (if positive). Intrinsic value represents the amount that an option is "in-the-money," reflecting the potential profit by exercising the option and then selling the underlying stock's shares at a higher price than the current market value.

For instance, if you have a call option allowing you to buy a stock at a $50 strike price, and the stock is currently trading at $60, the intrinsic value is $10 ($60 - $50). Similarly, for a put option, if the stock is trading at $40, the intrinsic value is $10 ($50 - $40).

Time Value: Also known as extrinsic value, time value reflects the additional worth of the option beyond its intrinsic value. It accounts for factors such as the time remaining until expiration, market volatility, and the potential for the underlying asset's price to move in the future. Time value diminishes as the option approaches its expiration date, reflecting the decreasing likelihood of significant price changes.

In addition, this is the extra value added to the option because there's still time left before it expires. It's like paying for the chance that the stock's price will move in your favor before the option expires. As time passes, this value tends to decrease because there's less time for the stock to make big moves.

In summary, an option's premium may be comprised of both intrinsic value, reflecting its current in-the-money status, and time value, representing the potential for future price movements before expiration. Understanding the premium is essential for options traders, as it can be better inform their trading decisions and risk management strategies.