Option Contracts: Everything You Need to Know
Options contracts are agreements between 2 parties (buyer and seller) regarding a potential future transaction on an underlying security. 4 min read
Options contracts are agreements between 2 parties (buyer and seller) regarding a potential future transaction on an underlying security. Such contracts generally include securities, commodities, and real estate. It will give the purchaser the option to buy or sell an asset at a later date for a specific price. The price of the transaction, also referred to as the strike price, is predetermined in the contract. Specifically, there are two types of options contracts – a put and a call. Such options can be purchased, which will include the predetermined price that is based on speculating the direction in which the stock will move.
For example, assume that a trader holds shares for a company that is worth $100/share. The trader may decide to sell a call option with a strike price of $105 to generate additional income for an option premium, which is paid by the buyer who will also speculate that the price of the share will increase to $105 at a certain point in time. Option sellers, however, are obligated to engage in the transaction if the buyer chooses to execute a call option to buy the security during that time.
What Information Will Be in the Contract?
The following information will be included in the options contract:
- The underlying security
- Type of option (call or put)
- Commodity involved
- Current date in which the contract is being enforced
- The strike price
- The expiration date of the contract
A typical options contract will cover approximately 100 shares; however, the amount of shares might be adjusted due to mergers, dividends, or stock splits. The seller must perform under the contract if the buyer chooses to purchase the option while the contract is valid. Once the contract has expired, however, the buyer can no longer utilize his or her ability to act on the option at that particular strike price. But if the buyer chooses not to buy the option, the seller cannot force performance under the contract.
As previously noted, options contracts are common in real estate. For example, the seller and buyer of the property will agree upon a sale price. However, during the beginning stages of the process, the buyer will need to obtain financing before purchasing the property. If the buyer agrees to all of the terms within the designated time period, then a binding contract has now been created. Therefore, the option will expire at the end of the period identified in the contract, regardless of whether or not the buyer chooses to purchase the property.
What Is the Difference Between an Options Contract and a Firm Offer?
The key distinction between an options contract and firm offer is that the options contract is merely an open-ended contract that is primarily supported by consideration and a designated time frame. It need not be a contract for the sale of goods. However, a firm offer must involve the sale of goods. Furthermore, a firm offer remains open for a period of time whereby the offer cannot be revoked.
Call options are used to leverage the price of a stock or index. The buyer of a call option can purchase a certain number of shares at a strike price, both of which are predetermined and included in the contractual language. The seller, also known as the writer, receives a premium amount for selling stock at the strike price to the buyer. For example, let’s assume that shares of a particular security are currently trading at $1/share. The writer (seller) might want to sell calls at $1.50/share with a two-month expiration date. If the share price remains below $1.50 and the options period expires, the seller will keep the stock and collect another premium by offering calls again with a new expiration date. If the price of each share does in fact increase to $1.50, then the buyer will call the stock from the seller, and purchase them at $1.50. The buyer also has the choice of re-selling the options if purchasing those shares doesn’t have a favorable outcome for the buyer.
Put options are purchased to profit from a decline in the price of stock. The purchasers of such options are guessing as to the decline in a share or index. Such buyers own the right to sell shares at the strike price in the contract. Therefore, if the price of each share is reduced below the strike price identified in the contract, and the reduction in price occurs before the contract expires, then the buyer can either choose to assign the shares to the seller for the strike price or sell the contract altogether.
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