Key Takeaways

  • Stock contracts typically refer to options contracts, which give the holder the right, but not the obligation, to buy or sell shares at a specified price before expiration.
  • There are two main types: call options (buying) and put options (selling).
  • Concepts like in the money, at the money, and out of the money describe an option's value relative to the underlying stock price.
  • Options are used for speculation, hedging, or generating income, but carry substantial risk and complexity.
  • Advanced strategies include covered calls, protective puts, and spreads, each with distinct risk/reward profiles.

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.

Out of the Money and Breakeven Points

When the strike price of an option is not favorable compared to the current market price of the underlying stock, the option is said to be out of the money (OTM). For call options, this means the strike price is higher than the market price; for puts, it means the strike price is lower.

A breakeven point is the stock price at which exercising the option leads to neither profit nor loss, accounting for the premium paid. For example:

  • A call option with a $50 strike price and $5 premium has a breakeven of $55.
  • A put option with a $60 strike price and $4 premium breaks even at $56.

Understanding OTM and breakeven levels is critical in evaluating potential outcomes and risks of an options trade.

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.

Risks and Considerations

While options can enhance portfolio flexibility, they come with significant risks:

  • Time Decay: Options lose value as the expiration date approaches, especially if out of the money.
  • Volatility Risk: Sudden market swings can lead to rapid losses or gains.
  • Liquidity: Some options may have low trading volume, making them harder to exit.
  • Complexity: Misunderstanding contract terms or strategy mechanics can result in losses exceeding the initial premium.

Because of these risks, options trading is generally recommended for knowledgeable investors or those working with experienced advisors. You can consult a securities attorney through UpCounsel if you need legal help understanding or drafting stock-related contracts.

Common Options Trading Strategies

Options allow for sophisticated strategies that go beyond simple buying and selling. Common strategies include:

  • Covered Call: Selling a call option while holding the underlying stock to generate income.
  • Protective Put: Buying a put option to hedge against potential losses in a stock you own.
  • Straddle: Buying both a call and a put with the same strike price and expiration to profit from volatility.
  • Vertical Spread: Buying and selling options of the same type and expiration but different strike prices to limit risk and potential return.

Each strategy has specific use cases and risk profiles. Investors should understand the implications and margin requirements before executing these trades.

Key Elements of an Options Contract

Each stock options contract contains several standard components:

  • Underlying asset: The specific stock tied to the contract.
  • Strike price: The fixed price at which the stock may be bought or sold.
  • Expiration date: The final date the option can be exercised.
  • Premium: The cost to purchase the option, determined by market conditions.

The value of an option depends on factors like time to expiration, stock volatility, interest rates, and whether the option is in or out of the money.

Types of Options Contracts

Options contracts fall into two main categories:

  • Call options: Give the buyer the right to purchase stock at the strike price.
  • Put options: Give the buyer the right to sell stock at the strike price.

These contracts can be used by:

  • Hedgers, who want to protect against downside risk.
  • Speculators, who aim to profit from price movements.
  • Income-seekers, who use strategies like covered calls to earn premiums.

Options are traded on organized exchanges like the Chicago Board Options Exchange (CBOE) and are standardized in terms of contract size (usually 100 shares), expiration dates, and strike intervals.

Frequently Asked Questions

1. What are contracts in stocks? Contracts in stocks, typically referring to stock options, are financial agreements that give the holder the right to buy or sell shares at a predetermined price before a set expiration date.

2. What’s the difference between a call and a put option? A call option gives the holder the right to buy shares; a put option gives the right to sell. Both can be used for hedging or speculation.

3. How do I know if an option is in the money? An option is in the money when exercising it would result in a profit. For calls, this means the stock price is above the strike price; for puts, it's below.

4. What happens when an options contract expires? If not exercised before expiration, the option becomes void. In-the-money options may be automatically exercised, depending on the brokerage.

5. Can I lose more than I invested in an options contract? For buyers of options, the maximum loss is the premium paid. However, sellers (writers) of options can face significant or unlimited losses.

If you need help with contracts in stocks, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with companies like Google, Menlo Ventures, and Airbnb.