An options contract gives you the right to buy or sell an asset in the future at a price agreed today.
- Traders use options contracts to ‘lock in’ a price in order to protect themselves against volatile markets or speculate on future performance
- Options contracts differ from futures contracts because they represent a right to buy or sell, rather than an obligation
- Options are available on a range of markets, but are most commonly used to trade commodities or speculate on stocks
What is an options contract?
It’s a financial product that gives you the opportunity to buy or sell an asset within a specified time frame. An option is like paying for early-bird access to a ticket portal: you pay a premium for the right to buy a ticket later on, but you don’t have to if you change your mind.
With an options contract, you specify the parameters of the trade in advance. You agree on the price, the amount you want, whether you want to buy or sell the asset, and a timeframe within which you can activate it. Then you pay a fee – known as the premium – upfront, and the amount varies depending on how risky a deal it could be for the broker.
There are two types of options, known as ‘calls’ and ‘puts’. That’s because options give you the right to buy (a call option) or the right to sell (a put option), and the two terms are used to differentiate them.
Why are options useful?
Options can be used in different ways depending on the goals of a particular trader. They can help people mitigate risk, be used as a means of speculating on price changes in the future, or work as an avenue for traders to open highly leveraged positions.
The best example of why options are useful is as a way of reducing risk from exposure to a particular asset. If you bought 100 shares in Apple at $150 each – for a total cost of $15,000 – then you could lose a lot of money if the share price collapsed. An options contract offers a way of lowering the danger of such a position.
Once you own those shares in Apple, you could buy a put option that gives you the right to sell 100 shares at $150 apiece at any time in the next three months. You have to pay a premium to do so, of perhaps $0.20 per share. If the price did indeed collapse, you could exercise the option and sell the shares. If not, you would just lose the $20 premium that you paid.
Options contracts involve a lot of specific terms that might be unfamiliar but they are all quite simple to explain. These are the terms that you’re most likely to read about, along with a quick explanation of each one.
- Call. A call option is the right to buy an asset at a set price within a specified timeframe.
- Put. A put option is the right to sell an asset at a set price within the specified timeframe.
- Premium. The premium is the price you pay for the option itself.
- Strike price. The strike price is the agreed price at which you can buy or sell an asset, as specified in the options contract.
- Expiration date. The expiration date refers to the final day upon which you can exercise the option.
Where can I learn more?
For more information about options contracts, and other key financial concepts, check out our full course page. To learn more about investing, our helpful courses will take you through everything you need to know:
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