What is an options contract?
Options contracts are financial derivatives that act as agreements between two parties, designed to facilitate transactions of underlying assets. Often an agreement between a buyer and seller, options contracts give purchasers a right to buy or sell agreed-upon assets at a preset price, often referred to as the strike price.
The two main types of options contracts are:
- Put Options
- Call Options
A Call Option is a type of option contract that gives a buyer the right to buy a given asset at a set price before a predetermined expiration date. The strike price, in this case, is the predetermined price that the buyer can buy the asset.
While the buyer purchases the security at a predetermined price, the seller receives a premium amount for selling the asset at the strike price.
Call options accord buyers the right to buy securities at the agreed price over a given time regardless of the price rising or falling. Should the price of the underlying asset move above the strike price, then a call options buyer stands to generate a profit on buying at a much lower price prior to the expiry of the option.
A put option is an options contract that allows a seller to sell an underlying asset at a set price before the expiration period. Just like call options, put options have a predetermined sell price at which the seller can sell the security.
A put option becomes more valuable on moving below the strike price, allowing the buyer to offload the option to make more money on the price difference. Put options are thus purchased to make a profit from declining prices of securities. The purchasers of put options are of the opinion that the price of an underlying asset will continue to decline below the strike price.
Options Contract Basics
Call options are purchased with a view of making a profit on prices of underlying assets increasing relative to the strike price. Conversely, put options are purchased with a view of making profits from declining prices relative to the strike price.
Likewise, call option buyers have the right but not the obligation to purchase the number of shares indicated in a call option contract. Similarly, put buyers have the right to sell shares at the strike price in a contract prior to the expiration.
Both put and call options are normally used for hedging purposes in the stock market. In addition, options make it possible to leverage a position in a stock while mitigating the risk of a full purchase. Option contracts are beneficial in markets that experience high levels of price fluctuations.
Options Trading Drawbacks
Option trading exposes sellers to amplified losses much greater than the price of the contract as they are obliged to buy or sell shares at an agreed price, even if it is unfavourable.
Options trading is not for everybody. Before you can start trading, you must apply for approval through a broker. Margin requirements in options trading can run up trading costs.