What is an option contract?

I’m going to try to provide a basic overview of what an option contract is however there are many good resources that could probably do a better job. My intent is to provide just a few of the basics to get you started and give you some pointers to better resources.

With that in mind, here goes…

An option is in fact a contract that has certain obligations for the seller or originator of the contract and offers certain rights for the buyer or holder of the option contract.

An option is a derivative product – meaning it derives its price from the instrument it represents. Options exist for a variety of underlying instruments including stocks, ETFs, Indexes, futures, currencies, commodities, and more. For the purpose of this discussion, we’ll restrict our discussion primarily to options on stocks. Later, we’ll cover index options and ETFs.

An option comes in two flavors, call options and put options.

Call options

A call option is an option contract that gives the buyer the right to purchase the underlying instrument at the agreed upon price (the strike price). Therefore, the seller of the call option is obligated to sell the underlying instrument to the buyer at the strike price.

Ok, that may sound a little complicated so let’s use some non-stock related examples.

Let’s say you want to purchase a house that is currently selling for $100,000 but you aren't sure you want to be obligated yet. However you believe that the property value may go up and you don’t want to pay any more for the property.

Today is January 1st and you convince the seller to sell you an option on the property for a given price that entitles you to purchase the property for $100,000 at any time between now and December 31st. The price you pay for the option is $2,000.

Now, let’s assume that 6 months from now the value of the property has risen to $120,000. You now have several choices.

  1. You would like the buy the property so you use your option to make the purchase for $100,000 and you now have a property worth more than you paid for it.
  2. You decide you don’t want to buy the property, however since the value of the property is now more than the value of the option, you can use the option to purchase the property for $100,000. You can then turn around and sell it for $120,000 making a $20,000 profit. But wait… you spent $2,000 to purchase an option that you were able to use to buy the house, so you actually only realized an $18,000 profit from a $2,000 initial expense.

On the other hand, what happens if the value of the property decreases to $80,000? Would you still want to use the option to purchase the property for $100,000?

NO – why would you when you could simply go out to the market and buy it for $80,000? Most likely, you would simply walk away and the worst that happens is you lose the $2,000 you paid for the option.

Why would you buy a call option?

  1. You want to own a stock at close to the current price but you don't want to take a risk by paying full price right now
  2. You think a stock will go up and you want to take advantage of the move with out paying full price for the stock

Put options

A put option is an option contract gives the buyer the right to sell the underlying instrument at the agreed upon price (strike price). This means the seller is obligated to buy the underlying instrument from the seller at the strike price.

Let’s use another example to illustrate. Let’s say you went ahead and purchased the property for $100,000. If you purchased the property with a loan, you are required to also purchase an insurance policy to protect the value of the property. Most likely, you would purchase a $100,000 replacement value policy. You might purchase a policy like this for maybe $600/year.

What would happen if at some point during the year, a fire erupts in your house and completely destroys it? Now, what would the property be worth? Pretty close to $0 right? Ok, maybe the property itself would be worth something. Let’s say that the property is worth $20,000.

Without insurance, you would have lost $80,000. However, the insurance policy you bought allows you to replace all that was lost and restore it back to original value. In that case, wouldn't the policy be worth $80,000 theoretically?

Ok, that's where the analogy breaks down. In the options world, if you bought a $20 put option on a stock that is currently trading at $25 and then it suddenly drops to $15, you could do one of two things.

  1. You could go out and buy the stock at market price ($15) and then use your $20 put to force the option seller to buy the stock for $20 making a $5 net profit
  2. You could just sell the $20 put to someone else since it has a guaranteed value of $5

Why would you buy a put option?

  1. You might be holding a stock you bought at a certain price and want to protect the value from a severe drop in price
  2. You may believe that a certain stock will drop in price and you want to take advantage of that move as an alternative to shorting the stock

Components of an option contract

An option contract contains the following terms.

  • Agreement to sell (call) or buy (put)
  • At an agreed upon price – Strike price
  • By a specified date – expiration date
  • For an agreed up price – option premium

Let’s take a little time to break each of these down a little further.

Calls – A call option provides the buyer the right to purchase a stock at the strike price. It also obligates the option seller to sell the stock at the strike price.

Puts – A put option provides the buyer the right to sell a stock he may or may not own at the strike price. It also obligates the option seller buy the stock at the strike price.

Strike prices – The strike price is the agreed upon price for the underlying instrument (stock in this case). In the stock options market, strike prices typically are pre-defined based on the price of the underlying instrument. They may be in $2.50 increments (ex. $2.50, $5, $7.50, $10) or they may trade in $5, $10, or even $25 increments. Usually the higher the underlying instrument the larger the increments.

Expiration date – An option contract has a pre-defined expiration date and is usually offered for each month. Options on stocks and ETFs typically expire the 3rd Saturday of the month at noon. This means they will stop trading the day before (3rd Friday) at the close of the market.

Option premium – This is the price the buyer will pay for the option contract. There are many factors that affect the option premium for a given strike price including the price of the underlying stock, how long until expiration, volatility in the market and more. Option premium pricing is a whole other discussion. Collectively, these are called option greeks.

Contract Multiplier - For stock, ETF and index options, one option contract will typically control 100 shares of the underlying. One thing to watch out for though is that occasionally, there will be an odd option contract, typically due to a stock split that will represent some number of shares other than 100. In all my strategy discussions, I assume a multiplier of 100. An option that is listed at $.50, will cost $50 per contract to purchase ($.50 X 100).

There is obviously a lot more to know about an option contract, particularly if you are an analytical type person. However, rather than trying to duplicate the excellent work of others, I'd rather just suggest some resources for additional information.

Some good websites

  • www.888options.com - This website is dedicated to helping options traders become better educated. It has some great basic stuff on it.
  • www.cboe.com - The CBOE is also committed to educated options traders. The more educated you are, the longer you'll be trading.

Some good books

  • Fundamentals of the Options Market - Michael S. Williams & Amy Hoffman
    I found this to be a really good beginning book, especially on the topics of option pricing and understanding volatility.
  • Option Volatility & Pricing - Sheldon Natenberg
    This is an even better book and really a 'must own' if you are serious about options trading. It offers a lot of similar material on volatility and pricing but is much more technical. In addition it offers some great ideas on strategies for taking advantages of the characteristics of options.

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