Option Contract Definition Examples Top 2 Types Of Options Contract

Option Contract Definition

There are 2 Parties to the Contract

Option Holder or Buyer of the Option: It pays the initial cost to agree. The call option buyer benefits from the price increase but has limited downside riskDownside RiskDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. read more if the price decreases because, at most, he can lose the option premium. Similarly, the put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more buyer benefits from a price decrease but has limited downside risk in the event when the price increases. In short, they limit the investor’s downside exposure while keeping the upside potential unlimited.Option Seller or Writer of the Option: It receives the premium at the initiation of the option contract to bear the risk. The call writer benefits from the Price decrease but has unlimited upside risk if the price increases. Similarly, the writer benefits if the price increases as he will keep the premium but may lose a considerable amount of price decrease.

Options are currently traded on stock, stock indicesStock IndicesThe stock index, which is also known as the stock market index, is a tool used to determine the performance of shares/securities in the market and to calculate the return on the stock of their investment investors use it to have knowledge about the performance of investments and access the total value they possess.read more, futures contracts, foreign currency, and other assets.

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Types & Examples of Option Contract

#1 – Call Option

Let’s take an example. The call owner is bullish (expects the stock price to rise) on the movement of the underlying assets. It gives the owner the right to buy an underlying asset at a strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more at the expiration date. Consider an investor who buys the call option with a strike of $7820. The current price is $7600, the expiration date is in 4 months, and the price of the option to purchase one share is $50.

Long Call Payoff Per-Share = [MAX (Stock Price – Strike Price,0) – Upfront Premium Per ShareCase 1: if the stock price at expiration is $7920, the option will be exercised, and the holder will buy it @ $7820 and sell it immediately in the market for $7920, realizing a gain of $100 considering the upfront premium paid of $50, the net profit is $50.Case 2: if the stock price at expiration is $7700, the option holder will choose not to exercise as there is no point in buying it at $7820 when the stock market price is $7700. Considering the upfront premium of $50, the net lossNet LossNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet.read more is $50.

#2 – Put Option

It gives the owner the right to sell an underlying asset at the strike price at the expiration date. Let’s take an example. Consider an investor who buys the put option with a strike of $7550. The current price is $7600, the expiration date is in 3 months, and the price of the option to purchase one share is $50. The put owner is bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more (expects the stock price to fall) on the stock price movement.

Long PutLong PutLong put is a strategy used in options trading by the investors while purchasing a put option with a common belief that particular security’s price shall go lower than its striking price before or at the arrival of the date of expiry.read more Payoff Per-Share = [MAX (Strike Price – Stock Price, 0) – Upfront premium Per ShareCase 1: if the stock price at expiration is $7300, the investor will buy the asset in the market at $7300 and sell it under the terms of put option @7550 to realize a gain of $250. Considering the upfront premium of $50, the net profit is $200.Case 2: if the stock price at expiration is $7700, the put option expires worthless, and the investor loses $50, which is the upfront premium.

Uses of Option Contracts

#1 – Speculation

The investor takes an option position where he believes that the stock price is selling at a lower price but can considerably rise in the future, leading to profit. Or in case he believes the market price of a stock is selling at a higher price but can fall in the future, leading to profit. They are betting on the future direction of the market variable.

#2 – Hedging

The investor already has exposure to the asset but uses an option contract to avoid the risk of an unfavorable movement in the market variable.

Option Contracts are Exchange Traded or Over the Counter

Exchange-Traded Options have standardized features with respect to expiration dates, contract size, strike price, position limits and exercise limits and are traded in an exchange where there is minimum default riskDefault RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more.The Counter Options can be tailored by private parties to meet their particular needs. Since they are privately negotiated, the option writer may default on its obligation. Post-1980 over the counter marketOver The Counter MarketOTC markets are the markets where trading of financial securities such as commodities, currencies, stocks, and other non-financial trading instruments takes place over the counter (instead of a recognized stock exchange), directly between the two parties involved, with or without the help of private securities dealers.read more is much larger than the exchange-traded market.The option can be either American or European: American optionAmerican OptionAn American option is a type of options contract (call or put) that can be exercised at any time at the holder’s will of the opportunity before the expiration date. It allows the option holder to reap benefits from the security or stock at any time when the safety or supply is favorable. A European option is the exact opposite of an American option wherein the option holder cannot sell the option until the day of expiration, even when it is favorable. In addition, there is no geographical connection concerning the names since it only refers to the execution of the options trade.read more can be exercised at any time up to expiration date whereas European optionEuropean OptionA European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In layman’s terms, once an investor has purchased a European option, even if the underlying security’s price moves in a favourable direction, the investor cannot take advantage by exercising the option early.read more can only be exercised on expiration date itself. Most of the option traded in the exchange are European options, which are easier to analyze than American option.

Drivers of the Option Contract Value

The underlying stock‘s volatility: Volatility measures how uncertain we are about future price movements. The higher the stock volatility, the greater the value of the option. As volatility increases, the chance of stock appreciating or depreciating increases.Time to Maturity: The more time left to expiration, the greater the values of options. The longer maturity option is valuable as compared to a shorter maturity contract.The direction of underlying stock: If the stock appreciates, it will positively impact the call option and negatively impact put options. If the stock falls, it will have the opposite effect.Risk-free rate: As the interest rate increases, the expected return required by investors tends to increase. In addition, discounting the future stream of cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more to present value using a higher discount rate decreases the option value. The combined effect increases the value of the call option and decreases the value of the put option.

Advantages of Option Contract

Provide Insurance: Investors can use Option contracts to protect themselves against adverse price movement while still allowing them to benefit from favorable price movement.Lower Capital Requirement: Investors can take exposure to stock price by paying an upfront premium much lower than the actual stock price.Risk/Reward Ratio: Some strategies allow the investor to book considerable profit while the loss is limited to the premium paid.

Disadvantages of Option Contract

Time Decay: When buying an option contract the time value of the options diminishes as maturity approaches.Involves Initial Investment: The holder must pay an upfront non-refundable premium which it can lose if the option is not exercised. During volatile markets, the option premium associated with the contract can be quite high.Form Leverage: The option contract is a double-edged sword. It magnifies financial consequences that can result in huge losses if the price does not move as expected.

Conclusion

There are two types of options: call, which gives the holder the right to buy an underlying asset for a certain price by a certain date. A put option gives the holder the right to sell the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more at a certain date for a certain price.There are four possible positions in options markets: a long call, a short position in the call, a long position input, and a short position input. Taking a short positionShort PositionA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more in an option is known as writing it.An exchange must specify the terms of the options contracts it trades. It must specify the contract size, expiration time, and strike price, whereas Over counter trades are customized between private parties to meet their specific requirements.