Options are an important part of financial markets. Options contracts allow buyers and sellers profit from changes in share prices, which makes them vital for traders. Anyone can purchase options, but there are risks. If you are considering purchasing options or signing an options contract, a Priori securities lawyer can help you understand the obligations and risks involved with the agreement.
About Options Contracts
Options contracts, commonly referred to as just “options”, are a common form of derivative that allows buyers and sellers to contract for a purchase of an asset at a later date and at a specific price.
What Is an Options Contract?
An options contract is a financial agreement that details a possible future transaction on a specified underlying asset at a specified price. Essentially, an options contract allows the holder to buy or sell an underlying security at a given price at a later date if they deem it desirable, regardless of the market price of the asset when the option is exercised. These contracts are carried out between a grantor, who is obliged to perform if the option is exercised, and the beneficiary, who retains the choice whether or not to exercise the option at the predetermined time.
When Are They Used?
Options are commonly used with respect to the right to purchase stock in a company, but they can derive from virtually any asset. Options contracts are also used with respect to bonds, indices, foreign currencies, real estate property and commodities.
Types
There are two basic types of options contracts: put options and call options.
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Put Options. Put options allow the beneficiary to sell an asset at the agreed-upon price. The grantor must buy the asset if the option is exercised.
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Call Options. Call options allow the beneficiary to buy an asset at the agreed-upon price. The grantor must sell the asset if the option is exercised.
Key Terms and Provisions of Options Contracts
There are several key terms and provisions commonly found in options contracts, as follows:
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Duration and Expiration Date. Options always have a limited duration, and they can’t be exercised past the expiration date of the contract. Generally, options have a rather limited duration, such as just a few weeks, but in cases where the underlying asset is real estate, they can sometimes last for years.
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Strike Price. This is the price at which the asset can be purchased. In most options contracts, the strike price does not change, but longer options contracts sometimes periodically reassess price using predetermined mechanisms.
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Consideration. U.S. contracts generally are required to include “consideration” (i.e. an exchange of value) in order to be valid. This includes options contracts -- even though the purchase of the actual underlying asset may not happen, the option to obtain the asset is a thing of value.
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Option Fee. The price paid by the beneficiary of the option as consideration for entering into the contract.
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At the Money. If options are bought or sold “at the money," it means that the strike price is the same as the market price of the underlying security.
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In the Money. If options are “in the money," it means that the strike price is below the market price of the underlying stock for call options and above the market price for put options. The beneficiary profits if options are in the money.
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Out of the Money. If options are “out of the money”," it means that the strike price is above the market price of the underlying stock for call options and below the market price for put options. The grantor profits if options are out of the money.
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Underlying Asset. The underlying asset, the actual asset that can eventually be bought or sold, must be specified within the options contract. Technically, the contract itself is based on its derivative.
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American Style Options. American style options allow the beneficiary to exercise the option at any time through the expiration date.
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European Style Options. European style options can only be exercised or not on the expiration date.
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Physical settlement. When the option is exercised, the actual asset is transferred to the buyer.
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Cash settlement. When the option is exercised, a cash payment is made equivalent to any profits that would be made selling the asset at market value.
FAQ
Why are options contracts appealing?
Options contracts can be appealing for different reasons, depending on the underlying asset and the identity of the participants in the exchange. Traders use options as a means of hedging their stock positions for possible profit. Real estate options contracts allow developers to secure multiple properties needed for a project before actually purchasing any.