An option contract is a type of derivative security that gives the buyer the right, but not obligation to purchase or sell an underlying asset at an agreed-upon price within a specified time frame. They are one of the most used and traded financial instruments in today’s market.
This article will explain what options contracts are, how they work, and some terminology commonly associated with them. It also includes further reading for those who want to learn more about this topic.
What is an Option Contract?
An option contract is an agreement between a buyer and seller who want to trade stocks. When you buy an option contract, it gives you the right but not obligation to either buy or sell a security at a specified price for a specified time.
In the stock exchange, there are two types of option contracts: one is for buying stock, which is called “CALL Options”, and another one is for selling stock, which is called “PUT Options”. Each contract has its own terms like price, quantity, and time.
The price of options depends also on several factors like strike price, underlying asset price, time remaining until the expiration date, volatility of the market, and quantity.
The buyer (also called the holder) of this contract has the right to exercise their options of selling or buying the underlying stock anytime before the expiration date. The seller of this contract is obligated to fulfill the contract.
Options Trading Terminology:
In the U.S, each contract represents 100 shares. A “CALL” option gives you the right to buy 100 shares of a particular stock at an agreed-upon price within a given time frame, and “PUT” options give the owner of the contract the right to sell 100 shares or other securities.
So now let’s look at some of the common terminologies used in Options Contracts:
Option Writer: The creator of the Option Contract.
Strike Price: The price at which the stock must be bought or sold when exercising the option.
Options Duration: It is a until option expiry date..
What are CALL Options?
CALL options give buyers the right, but not the obligation to buy underlying securities like stocks at a set price within a certain time frame.
Here is an example based on an actual CALL options contract:
You are a buyer of Apple Inc. You believe that Apple’s stock price will go up and you would like to profit from this increase. To do so, you buy one June 30, 2021 CALL Option, Let’s say $175 strike CALL Options is priced at $1.55 (Total: $1,550 ). The option gives you the right to buy 100 shares of Apple stock for $175 per share before the contract expires- which is on June 30, 2021.
If Apple’s stock price goes up and ends higher than your CALL option purchased (say it hits $200), then you can exercise this CALL Option and buy the stock at $175. Your net profit would be $25 x 100 shares = $2,500. Since you paid $1550 to purchase this option your actual profit will be $950.
And in case Apple’s stock falls below $175, it would be unwise to exercise the CALL option as you can buy shares below the $175 strike price from the market. In this case, you will lose the premium you paid ($1550).
Benefits of CALL Options:
1. CALL Option allows you to buy the stock at a predetermined strike price, thus provides unlimited upside potential if the stock moves higher than the strike price.
2. It limits your loss should the stock fall. Your loss will be limited to the premium you paid.
3. They are cheaper than buying 100 shares of that particular security and still provide the benefit of owning a stock if the stock moves higher than the strike price.
What are PUT Options?
PUT options give their owners the right to sell the underlying asset at a set price within a certain time frame. When a person believes that the market price of the asset will fall significantly then buying a PUT option will prevent the buyer from losing money below the strike price.
Here is an example based on an actual PUT options contract:
Let’s say you bought a $175 strike PUT option at $1.50 (Total: $1500) So if a stock’s market value falls below $175 before June 30th, 2021, Let’s say stock price falls to $150 then you will have the right to sell that stock for $175. In this case, you would give $25 x 100 share = $2,500 extra compare to selling straight into the market. Since you paid $1500 to buy the contract your actual profit will be $1000.
If Apple’s stock price stays above $175 until the expiration date of June 30, 2021, the PUT option you bought will expire worthless and you will lose the premium you paid ( $1500 Loss ).
Benefits of PUT Options:
1. PUT option provides you downside protection if the stock falls below the strike price.
2. Max loss if limited to the premium you paid to purchase the PUT option.
Other Terminologies Used in Options Contract:
1. Ask Price: The lowest price that a seller is willing to accept.
2. Bid Price: The highest price any buyer is willing to pay.
3. Bid-Ask Spread Price: The difference between the Ask and Bid prices. For example, if the Bid is $2.10 and the Ask is $3.00, then the bid-ask spread will be $0.90.
4. Current (Mark) Price: The middle of Bid and Ask prices. For example, if the Bid is $2.10 and the Ask is $3.00, then the current price is $2.55.”
5. ITM (In The Money) Option: For the CALL option when the strike price is below the current stock price it is an ITM CALL option. If the strike price is higher than the current stock price for the PUT option, it is an ITM PUT option.
6. ATM (At The Money) Option: When the strike price is the same as the current trading price that option is called the ATM option.
7. OTM (Out of The Money) Option: When it comes to the CALL option when the strike price is higher than the current market price of the underlying asset, it’s called the OTM CALL option. For the PUT option when its strike price is lower than the current market price of the underlying asset, it’s also OTM.
8. Intrinsic Value: It is the value by which the option is in the money. For example, if the $150 strike CALL option is priced at $5.40 and the stock’s current trading price is $160, in this case, the call option is ITM by $5, so the intrinsic value is $5. In simple terms, only ITM options have intrinsic value and it will be a difference between the strike and the current price.
9. Extrinsic Value: Extrinsic value is the difference between the market price of an option and its intrinsic value. For example, if an option is priced at $5.40 then its intrinsic value is $5 then the option has $0.40 of extrinsic value. Extrinsic value highly depends on the expiration date. So the extrinsic value goes down as the expiration date comes closer. Extrinsic value is also called “Time Value”.
Conclusion:
CALL & PUT option can work as leverage to profit or hedge with a very small investment. The price of an option highly depends on market direction, volatility, interest rate, and many other factors. You may find options a little complicated to understand but as you start learning and trading options it will become easier to understand how they are price and how can you take advantage of the option to make a higher profit.
