What are options contracts and how do they work


You might have heard about options contracts in different kinds of contexts, such as an investor hedging his investment with an option, or a company locking in a future commodity price, or a trader trading stock options on the stock market, or a startup offering stock options to their employees. Options contracts are very versatile financial instruments, and, in this article, we will dive deeper into them.

What are options contracts, and how do they work?

An options contract gives the owner the right, but not the obligation, to buy or sell an asset at an agreed price during a defined period.

Want to learn more about options contracts? Read on…


What is an options contract in detail?

Suppose your mother has passionately collected antique furniture. As she downsizes due to her age, she has decided to give you her antiques as soon she moved out of her house into a smaller flat next year.

You, however, don’t have any time or space to deal with the old furniture. You tell your friend that has just opened his new antique business, and he wants to purchase the antiques as soon as they become available.

Your friend knows that the prices of antiques are going up at the moment. He’s not sure if his business will survive as it is a startup that isn’t break even yet. He also knows that antiques aren’t easy to come by, and it would be a great opportunity if his business continues to grow. The antiques today are worth $ 10’000.

Therefore, he’s asking you if he can pay you a premium of $800 for the option, but not the obligation to buy the furniture for $ 10’000 next year.

So, what’s the advantage?

  • You will get a premium of $800 paid today to guarantee your friend that he can purchase the antiques for $ 10’000 as soon they become available.
  • Your friend has the option to purchase the antiques at $ 10’000 when they become available, but if his business goes bust, or when the price of the antiques drops, he can withdraw from the purchase, with a loss of only $800.

In this example, the underlying asset were antiques. The underlying asset can, however, also be a stock, an index of stocks such as the S&P500, a currency, a commodity, comestibles, or any other asset. Options are a widely used instrument of companies to hedge against currency risk when purchasing goods in another currency.


What are the options contract’s main variables?

Premium

When purchasing an options contract, you will pay a premium to buy or sell an underlying asset at a specified price during a defined period. This premium won’t be refunded.

Strike price

The strike price is the specified price you want to buy or sell the asset.

Expiration date

The expiration date is the date by when the options contract expires.


What types of options are there?

Call Option

The option holder has the right, but not the obligation, to BUY shares of an underlying asset, at an agreed-upon price, during a specified period.

Put Option

The option holder has the right, but not the obligation, to SELL shares of an underlying asset at an agreed-upon price during a specified period.


How does a call option contract work?

Mary wants to sell her house for $ 250’000. Next to her place, there is a land plot, currently farmland, but the owner thinks about selling it to a company that wants to build low-cost flats. There is a request for a building permit on the land.

Charles wants to buy the house from Mary, but he doesn’t have the money yet. He will only have the cash in 3 months. So, he is offering Mary $ 2’500 for the option to buy the house for $ 250’000 if she takes the home of the market for the next three months.

If Charles returns with the money and sees the low-cost, flat building project on the neighboring land, he might not want to purchase Mary’s house for $ 250’000 because the house’s value decreased as the lovely views will be gone. Charles can withdraw from the purchase, as he has the option, not the obligation, to purchase the house.

If the farmer decides to keep the land and plant apple trees, which makes the view from Mary’s house even nicer, the price might go up to $ 270’000. However, because Mary gave Charles the guarantee to sell her home to him at $ 250’000 and received a premium for it, she has to sell him the house at that price.

So, Charles is in control of an asset for $ 250’000 over three months, for which he only paid $ 2’500.

How to trade a stock call option contract

If you buy a stock call option, you bet that the stock will go up in price.

If a stock is trading at $30, for example, and you think it will go to $40, you could purchase a stock call option at $35 strike price for 35 cents. If the stock now rises to $40, you can make use of your call option and buy the stock at $35. This gives you a profit per share of $4.65, and the person that gave you the option will lose out on the higher yield.

However, if the stock doesn’t rise during the agreed period, then the call expires, and you’ll lose the 35 cents per share. The person that gave you the option will have earned the 35 cents per share.


How does a put option contract work?

Fred, the farmer, is dependent on his $ 50’000 Tractor. Without it, he can’t run his farm. But what is when it breaks down for some reason? Fred decides to purchase a zero-deductible insurance policy on his Tractor for the full amount of $ 50’000 (the strike price). The insurance company charges him $2000 (the premium) for the entire year’s insurance (the expiration date).

If the Tractor of Fred doesn’t have a problem, he will lose the $2000, but is okay with it, as he was protected.

If the Tractor of Fred breaks down due to an engine problem, which costs $8000, the insurance will pay him the $8000 in full. Under these circumstances, Fred will be pleased, as otherwise, he lost $8000, not only the $2000.

If the Tractor catches fire and burns down to a point where it’s unrepairable, the insurance company will pay Fred the full amount of $ 50’000. Fred will be very thankful that he had purchased the insurance option.

The insurance is okay with this, as they have sold many of these contracts, and most customers didn’t claim any money.

How would you trade a stock put option?

If you buy a put option, you are betting that the stock will go down in price.

If a stock is trading at $40, for example, and you think it will go down to $30, you could buy a stock put option at $35 strike price for 35 cents. If the stock drops to $30, you can make use of your put option and sell the stock at $35, even though the stock has fallen to $30. This would give you a profit per share of $4.65, and the person that gave you the option will lose out on the yield.

However, if the stock price doesn’t drop during the agreed period, then the option expires, and you’ll lose the 35 cents per share. The person that gave you the option will have earned 35 cents per share.


What is the benefit of buying a stock option?

Let’s say you buy 100 shares of ABC Inc. for $125 per share, so a total amount of $ 12’500, but you want to insure yourself against the risk of the stock going down.

You could purchase a put option for the 100 shares at the same price of $125 per share. You paid a premium of $500 for the put option, and the option will expire in 30 days.

If the stock price goes up from $125 to $132 per share, you have earned $7 per share, which equals to $700 ($7 * 100 shares) in profit. But because you’ve purchased the put option, which you now won’t use, you will have to deduct the $500 premium, which leaves you with a profit of $200. So, you won’t be that happy.

But what if the stock price fell from $125 to $113? You would have lost $12 per share, which equals a $1200 ($12 * 100 shares) loss.

But because you have purchased the put option, you can now use it and buy the shares at the price of $125. So instead of losing $1200, you only lost $500.

But from who do you buy the shares for the put option? You buy them from another market participant that purchased the stock and is lending it to you to sell it. For this person, this could be a loss if he sold his stocks at a lower price, but if this person doesn’t sell the stocks, at some point, they might go up in price again, and he didn’t lose anything.


Can I buy options contracts without owning the stock?

Yes, you don’t need to own the stock, to buy an option. Instead of buying the stock, you could just buy a call option on the stock. So, you pay a small premium for the right to buy the stock at a later date. This is cheaper than buying the stock directly.

So, let’s assume you want to buy 100 shares of ABC Inc at $115 a share. This will cost you $ 11’500 in total.

But instead, you can also buy a $115 strike call option for $500, which will expire in 30 days. This gives you the right to buy 100 shares at $115 per share anytime during the next 30 days.

If the stock goes up from $115 to $127 per share, you can use your call option and buy the 100 shares at $115. This puts you $12 per share in profit, which equals to $1200 for 100 shares. But because you paid the $500 premium, your profit will only be $700. So, if you would have bought the stock directly, you would have made more money.

But what happens if the stock goes down? Let’s assume the stock goes down from $115 to $100 per share. If you had bought the stock, you would be at a loss of $1500. But because you bought the call option, you can simply not use it, so instead of losing $1500, you only lost the $500.

So, the benefit is that you have to put up much less capital, as you buy the option, and you’ll have less risk than if you purchased the stock. But in exchange, you will have to pay a premium, which will lower your profit.


How can I purchase options contracts?

You can buy options contracts through your broker. If you use an online broker, usually you will see something that is called an Option Chain.

The Option Chain is a list of all offered options contracts. Options contracts are traded in bundles of 100 shares. When you want to purchase a call contract, you will have to take the “Ask price” and multiply it by 100 shares to get the purchase price. When you want to purchase a put contract, you will have to take the “Bid price” and multiply it times 100 to get the purchase price.


How can I buy options contracts cheaper?

Let’s say the stock of ABC Inc is currently at $65.

You see a call option at a strike price of $60 with a premium of $6.50 ($650) and another call option at a premium of $1.50 ($150) with a strike price of $70.

You can buy the $60 one for $650 and sell the $70 one for $150. This brings the net cost down to $500. This is called buying a vertical call spread and can be used to reduce your cost.


What other types of options contracts exist?

One other type is employee stock options (ESO). We will not cover these in this article.

Chris

Chris is an IT Project Portfolio Manager within the financial industry. Due to the nature of his role, he is engaged to study Financial Markets and is an active investor.

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