Options Contract: Definition, How They Work

What Is an Options Contract?

An options contract is an agreement between two parties with the purpose of giving the holder of the contract the right to buy or sell the underlying asset at a specified price within a certain time.

Common types of assets an options contract may cover include:

• Stocks
• Securities
• Real Estate

Possibly the most important aspect of an options contract is that while it gives someone the right to buy or sell an asset, the individual who purchases the option is not required to buy or sell.

There are two kinds of options contracts, called call and put options. You can buy options contracts to speculate on stocks, or you can sell these contracts to generate income.

Typical stock options contracts cover 100 shares of an underlying stock, although this amount can be adjusted for:

• Mergers
• Special dividends
• Stock splits

How Does an Options Contract Work?

An options contract includes terms that specify:

• The contract's expiration date
• The strike price, or the price at which an underlying asset may be transacted
• The underlying asset

You can generally purchase call options as a leveraged bet on a stock or index's appreciation. You generally purchase put options, on the other hand, to make a profit when prices decline.

Call option buyers have the right, but are not required, to buy the amount of shares that the contract covers at the set strike price. The opposite is also true: Put buyers have the right but are not required to sell their shares at the strike price a contract sets.

However, option sellers must transact their side of any trade if the buyer chooses to either execute the call option and purchase the underlying asset or execute the put option to sell the underlying asset.

Traders typically use options for hedging or speculation. This is because options usually cost just a part of what the underlying securities themselves would cost. You can use options as a way of getting leverage, as they allow an investor to bet on a stock without needing to buy or sell those shares outright.

What Is a Put Option?

You would typically purchase a put option when you expect to profit from the price of an asset declining. Buyers of a put option own a right to sell their shares at the strike price listed in the contract.

The buyer of a put option can only exercise their right to sell the shares to the seller of the contract at the strike price. The buyer also has the option to sell their contract if the shares aren't held in the portfolio.

What Is a Call Option?

You would typically buy a call option to leverage the price of an asset such as a stock, index, or other asset. You have the right to buy a set amount of shares at the strike price, but are not obligated to make the purchase. The contract should specify both the number of shares (or other assets) you purchase as well as the strike price.

When a call option transaction occurs, the position opens when the buyer purchases a contract from the seller. The seller is also called a writer in these transactions. The seller of a call option receives a premium when they assume the obligation to sell their shares at the strike price. The buyer benefits by getting the option to purchase the asset at the strike price, no matter if the value of the asset increases above that price in the period of time covered by the contract.

Here is an article with more information about put and call options.

Why Do People Choose Options Contracts?

Options contracts have a few different advantages. These benefits include:

• The seller receives a premium: The seller of an options contract receives a payment (the premium). They get that premium regardless of what happens with the contract after that point. That's why you'll find options traders who use received premiums as a big amount of their portfolio income.
• The buyer can lock in their right, without paying a lot: The buyer of the option also benefits. They can lock in their right to acquire the asset involved in the contract while only putting up a small amount of their money upfront. Since options contracts usually cost just a part of what the stock or other asset would cost — and the strike price is only due if the owner of the option decides to exercise their contract — the contract owner can gain the right to buy the asset at an attractive price.
• Options contracts give investors flexibility: If an investor uses options contracts well, it gives them the flexibility to take action with their portfolio and can help control risk while maximizing returns.

Image via Unsplash by austindistel

Common Areas Where Options Contracts Are Used

You will most frequently see option contracts in the financial industry. Options contracts are also sometimes found in real estate.

Options Contracts in Financial Industry

You can option the chance to buy or sell stock at a certain price for a specified period of time. Again, the buyer of the option is not obligated to exercise their option.

Options Contracts in Real Estate

Option contracts are sometimes used in real estate transactions. This is because a potential buyer of a property often needs additional time to complete steps such as securing funding and inspecting the property before they make an actual purchase. A seller and potential buyer can therefore agree on a certain selling amount while the buyer completes any necessary steps. Once the buyer agrees to terms within that set time period, the parties can create a binding contract for the transaction.

Here is an article with further reading about real estate options.

Options Contracts as Part of an Employment Offer

Many companies, especially startup companies and small businesses, offer options contracts as part of their benefits package. Employee options contracts offer employees the option to purchase stock in their company at a very reduced price. However, the price of the stock is determined by the option contract.

This arrangement has benefits for both the employer and employee. Both the business and the employee hope the company stock will rise in price, giving the employee incentive to work hard to make that happen.

What Is Included in an Options Contract?

Options contracts contain the elements of a typical contract, including:

• The offer made by a promisor
• The acceptance of a promisee
• Consideration (this is the exchange of something of value for something else of value)
• Mutuality of parties
• Legal capacity for parties to enter into the contract
• Legally acceptable terms

An options contract will typically include the following additional elements:

• The underlying security
• The type of option (whether it is a call option or a put option)
• The commodity involved in the contract
• The date on which the contract is enforced
• The strike price
• The expiration date

You may want to use an options contract to purchase stock options or real estate, or you may wish to offer stock options to employees. It's important to work with an experienced lawyer when creating these contracts.