Options Contracts

What Are Options Contracts in Options Trading?

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Options Contracts - Definition

Options Contracts are contracts that gives the holder of the contracts the RIGHT but not the OBLIGATION to buy or sell a specific asset at a fixed price.

Options Contracts - Introduction

Options contracts have been around for thousands of years. Yes, the stock options contracts traded over the options exchanges are merely a recent innovation. In fact, most people would already have some experience with options contracts before even trading their first stock options! Options contracts are not only being traded in the stock market but are also used very commonly in your other dealings in business or when purchasing a property.

This tutorial shall explore the different forms of options contracts and their characteristics.

What Are Options Contracts

In finance terms, options contracts are what is known as "Contingent Claims". A contingent claim means that the terms of the contract would be activated "contingent" (depending on) a "claim" (exercising the terms) by the holder of the options contract. Thats right, an options contract is simply any contract that gives its holder rights which the holder can choose to exercise or not. Indeed, any contracts with such characteristics are options contracts. As such, options contracts should not be taken only to be those stock options traded in the stock market.

Options contracts derive their values from the underlying asset that they cover. For instance, an options contract allowing you to buy a house for $500,000 when the house has a market value of $600,000 have a built in value (intrinsic value) of $100,000. This value of $100,000 is derived from the price of the house itself and is why options are known as "Derivatives" along with other derivatives such as Futures.

Examples of Options Contracts

You might also have used options in your everyday life without even knowing it. Some examples of options contracts that you might have encountered outside of the stock market are; Insurance, Option To Purchase and Employee Stock Options.

Insurance
Insurance is probably the most common form of options contract that you may have bought. Your fire insurance, automobile insurance, medical insurance are all options contracts. An insurance gives you, the holder, the rights but not the obligation to make a claim on the seller (the insurance company in this case) when certain conditions are met. When the mishap covered by the insurance policy happens, you can choose to make the claim against your insurance company or not, its up to you. Thats what it means to be a contingent claim. You also pay a "premium" to own the insurance policy, exactly like the premium you pay to buy call or put options in the stock market.

Option To Purchase
The option to purchase you signed (or "bought" since you pay a downpayment for it which cannot be refunded) when you are buying a house is another example of an options contract. Buyng the option to purchase from the seller of the property means that you have the right, but not the obligation, to activate the purchase of the property within the period covered by the option to purchase. Yes, you could let the option to purchase default and not take the "downpayment" back. The seller of the property, having sold you the option to purchase, is now committed to keeping the property open for your purchase anytime within the period covered by the option to purchase. This obligation on the part of the seller is exactly the same when you write options in the stock market.

Employee Stock Options
This is the form of options contract most directly linked to the options that are traded in the stock market. You might have received employee stock options as part of your compensation package from your company which allows you to buy shares of your company's stocks (whether listed or not) at a fixed price at anytime you want to (the contingent claim). As long as you do not exercise the rights to buy your company's shares, the obligation of the company to sell shares to you at the price stated remains in force.

As you can see above, most people would have owned at least one of the above options contracts before. Options contracts traded in the stock market, what is known as options trading, is a little more complex as there are two classes of options being traded; Call Options and Put Options. The options contracts listed above are all call options. Call options gives the holder the right to pay for an asset from the writer of the option when the options contracts are exercised; Receiving cash from exercising an insurance contract, paying for and receiving the house in an option to purchase and paying for and receiving the shares in an Employee Stock Option. This is exactly what call options do in options trading as well.

Options Contracts - Options Trading In The Stock Market

First of all, options aren't exactly traded in the stock market but in an options exchange. However, this distinction isn't that clear or important anymore as most stock exchanges are options exchanges as well and your options trading broker automatically trades in these exchanges for you so the actual "market" you are buying from is really quite invisible.

Unlike the call options being used in everyday life as outlined above, there is another class of options being traded in options trading and that is put option. Put Options allow their holder to SELL the underlying stock at a fixed price within the lifespan of the put options contracts. Yes, Call Options allow their holder to BUY the underlying stock at a fixed price while Put Options allow their holder to SELL the underlying stock at a fixed price. This makes put options excellent hedging instruments for stock portfolios in order to secure a fixed selling price for their stocks.

Like an insurance premium, you pay a premium to own call options and put options in options trading and the premium evaporates when options remain unexercised all the way through expiration, or what is known as "Expiring Out Of The Money".

Options Contracts - Characteristics

All options contracts have the following terms which give them the unique characteristics as contingent claims:

1. Parties
The writer (the one who sold the options contract) and the holder (the one who bought the options contract) must be specified. No one else but the holder of the options contract has the right of claim against the writer.

2. The Asset In Question
The asset and the quantity that the holder has rights to buy or receive within the contract period when exercised must be specified. In options trading, each options contract covers 100 shares of the underlying stock. An option to purchase would specify the apartment or house that is to be bought.

3. The Purchase / Sale Price of the Asset
The price at which the asset in question is to be traded at must be specified and this is what makes options so powerful. Owning the right to a fixed price in an ever-changing environment can give the holder of an option price advantages. This is why call options are bought when stocks are expected to go up and put options are bought when stocks are expected to go down.

4. The Expiration Date
All options contracts must have an expiration date as the asset covered by the contracts cannot be indefinitely reserved for the holder of the options. An insurance premium typically expires every year with a new premium to be paid for a new one (or "extension"). All stock options traded in the exchange have definite expiration dates.

These are the characteristics that makes options contracts what they are. Different forms of options contracts would have different other terms such as a premium to be paid (which doesn't exist in an employee stock option).

Options Contracts Example: AAPL is trading at $210. You bought one contract of AAPL's call options at the strike price of $210 for $230. AAPL rallies to $240 and you decided to exercise your options in order to buy and hold AAPL shares for long term investment at the price of $210. Upon exercise, the call options cease to exist and your account is credited with 100 shares of AAPL stock bought at $210.

Advantages of Options Contracts

The main advantages of options contracts is that the holder of an options contract reserves rights to own the underlying asset which is exercisable only on the holder's own discretion. Options contracts in options trading allows the holder to own the rights to the profits of a lot of shares using only very little money, resulting in leverage.

Disadvantages Of Options Contracts

The main disadvantage of options contracts is in the fact that the premium paid for the contracts go to "waste" if the options contract was never exercised. Just like paying for a year of insurance when you don't get into any accidents at all or buying a call options for a stock with strike price of $50 when the stock never reaches $50 in the first place.

Yes, you can lose all your money in options trading due to this reason and that is why you should only buy options using only money you can afford to lose. Just like buying insurance only with money you don't need for everyday living.

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