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What Is An Options Contract?

An options contract is an agreement between two parties to facilitate a potential transaction on an underlying security. The transaction involves the buying and selling of a security, usually a stock, at a specific price before the contract’s expiration date. Similar to futures and perpetual contracts, an options contract is a derivatives product. This means that it derives its value from an underlying security.

There are two types of options contracts — a call option, and a put option. The buyer of a call option has the right to purchase the underlying security at a predetermined price before its expiration date. The buyer of a put option has the right to sell the underlying security at a predetermined price before its expiration date. The predetermined price is also known as the strike price.

Many investors believe that options buyers are obligated to purchase or sell the underlying security. This is not true. The buyers are not required to purchase anything even though they have the right to do it.

There are two parties involved in an options transaction, the buyer and the seller. As we discussed, the buyer decides if they will purchase the underlying security attached to the options contract. If the security is purchased, this is known as an exercise. The options contract is “exercised” if the buyer of the option accepts delivery of the underlying security. The seller of the option is required to deliver the security to the buyer. The seller “writes” the options contract and the buyer purchases the contract.

How Does an Options Transaction Work: Example

Nancy is bullish on the future of online shopping. She believes that online shopping will increase dramatically during the next few years. Therefore, Nancy decides to invest in the world’s largest online retailer, Amazon (AMZN). However, she has a limited amount of funds for her AMZN investment. The current price of AMZN is $3,342 per share. Instead of purchasing the stock, Nancy decides to purchase an Amazon call option with a strike price of $4,000 per share. The expiration date of the call option is the 16 of April. This call option gives Mary the right (but not the obligation) to own 100 shares of AMZN at $4,000 per share. The current price of the call option is 48.95. Therefore, Nancy’s total cost is $4,895 (48.95 x 100). The cost of the option is known as the premium. The seller (i.e. writer) of the call option collects Nancy’s premium.

Successful Case

Nancy’s bullish forecast turned out to be correct. The price of Amazon stock exploded to the upside. On the expiration date of the call option, AMZN was trading at $4,301 per share. Therefore, the value of the stock was well above Nancy’s strike price of $4,000. Nancy has two choices. She can sell the call option and collect the proceeds or she can exercise the option. The current price of the call option is 301.20. Therefore, the option is valued at $30,120 (301.20 x 100). If Nancy sells the call option, she will have a nice profit of $25,225.

In addition to selling the call option, Nancy can exercise the option. By exercising the option, she will own 100 shares of AMZN at her strike price of $4,000 per share. The writer of the option is obligated to sell Nancy 100 shares at $4,000 per share. Whichever path Nancy selects will be quite profitable.

Nancy’s call option is considered to be “in the money” because the underlying security (i.e. AMZN) is trading above the strike price. Nancy has until the day of the option’s expiration date to decide if she wants to exercise the option or simply sell the option. She decides to exercise the call option and become the owner of 100 shares of AMZN. Based on the fact that she has exercised the option, the call writer will be required to establish a short position in AMZN at $4,000 per share.

Unsuccessful Case

What happens if AMZN is trading below its strike price on 16 April? Nancy’s call option would expire worthlessly and the call writer would keep the premium. The transaction would be complete. History tells us that 80% of all options expire worthlessly.

Vise Versa Approach

What if Nancy is bearish on AMZN instead of bullish? Instead of purchasing a call option, she would purchase a put option. The writer of the put option would collect the premium. If the put option is “in the money” on the expiration date, Nancy can exercise the option or sell the option. If she exercises the put option, the writer is required to buy 100 shares of AMZN on the expiration date. Nancy would be short AMZN at the strike price.

As you can see, options contracts offer several different strategies for the buyer. It is a great investment vehicle for active traders. This explains why call options and put options are the most widely used strategy for hedging.

Brief Summary Of An Options Contract

  • An options contract is an agreement between two parties to facilitate a potential transaction.
  • The transaction involves the buying and selling of a security, usually a stock.
  • A transaction occurs at a specific price before the contract’s expiration date.
  • An options contract is a derivatives product.
  • There are two types of options contracts, a call option, and a put option.
  • The buyer of a call option has the right to purchase the underlying security.
  • The buyer of a put option has the right to sell the underlying security.
  • The security is purchased at a predetermined price before its expiration date.
  • The predetermined price is known as the strike price.
  • If the security is purchased, this is known as an exercise.
  • The options contract is “exercised” if the buyer of the option accepts delivery.
  • The seller of the option is required to deliver the security to the buyer.
  • The seller is also known as the “writer” of the contract.
  • The seller “writes” the options contract and the buyer purchases the contract.
  • Options contracts are very popular among traders and investors.
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