What Are Contracts in Stocks?: Everything You Need to Know
The question of, “What are contracts in stocks?” often comes up in conversations about trading.3 min read
2. Options Contracts — Rights Without Obligations
The question of, “What are contracts in stocks?” often comes up in conversations about trading. In essence, stock options contracts enable the person holding them to sell or to buy shares of stocks at a set price at a future date.
In a case where the trader buys a call, he or she would be able to buy those shares at the "strike price," which is a fixed price. This applies even if the stocks are trading at a higher price at the time.
Buying the put, on the other hand, gives a trader the ability to sell his or her shares at the strike price at a later date, even if the stocks have devalued.
At the Money and in the Money
If it so happens that the strike price is equal to the cost of the underlying stock, then the option is referred to as being "at the money." As an example, if Google is trading at $620, and a trader is holding a January 620 option, then he or she is "at the money." This is irrespective of whether the option is a call or a put.
In contrast to “at the money," if the cost of the underlying security is greater than the current strike price, then a call option is referred to as being "in the money." It works the opposite way for a put option. A put is referred to as being "in," as opposed to "at," the money in instances when the strike price is higher than the cost of the underlying stock.
Consider the following example: If a trader bought Google January 620 call options today, and found that they were trading at $623 two weeks from now, then he or she would be “in the money” by $3. The math is simple:
- Take the new stock price of $623.
- Subtract the original strike price of $620, and you get $3 remaining.
In the same way, a January 625 put would have gained a profit of $2, bearing in mind the difference between the strike and the stock prices.
Options Contracts — Rights Without Obligations
Sometimes, the best option for a small business owner might be to have the ability to trade in an underlying investment without having any obligation to do so. In this case, an options contract is the way to achieve this.
It is important to bear in mind that options contracts have specific expiry dates. You can either allow the option to expire without using it, or utilize your option on or before the date of expiry. In addition, option contracts include the specific strike price at which the underlying investment may be purchased or sold.
It should be noted many investors will never consider an options contract because of the high-risk factor associated with them. On the other hand, a trader can make the most of an options contract by using it to lower his or her overall risk, as they provide insurance for a variety of unexpected circumstances.
Options contracts tend to have certain standard characteristics, which depend on what type of underlying investment it relates to. These contracts are publicly traded on exchanges. In terms of stock options, a typical options contract consists of 100 shares of underlying stock. Expiry dates can be chosen in various months, and the stocks usually expire on the third Friday of that month.
As the name states, options contracts are optional, and that is the most important aspect of them. The owner of such a contract can force the seller of the options contract to undertake any action that is specified within the contract. However, the owner is not obliged to do so. For example, in the case of put options, the owner of the option may sell underlying stock to whoever sold the option. If this is exercised, the seller of the option will have to purchase the stock from the option owner.
Call options work in a similar way:
- An option owner is within his or her rights to purchase underlying stock from whoever sold him or her the option.
- That seller is obliged to sell stock to the option owner as requested.
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