An option contract is an agreement between two parties to make transactions on underlying securities. Investors often purchase options contracts to hedge their assets from potential risk in the market. While some options contracts are purchased or sold over speculation from upward and downward trends in the market.
Options trading is complex and can be a difficult concept to grasp for beginners. In this article, we are going to break down the key points that options trader must know and how profitable option contracts can be.
How Do Option Contracts Work?
Options contracts are built on the assumption that buyers and sellers determine when evaluating future value of stocks. This could be an estimate that a stock will go up or down in value over a set period of time.
So, how do options contracts work? The two most common ways to use options contracts are by using calls and puts. Calls and puts are purchased to allow for investors to make profitable moves without having a large portfolio.
What Are Option Contracts in Simple Terms?
Options contracts are contractual agreements put into place by two parties. Typically, contracts are purchased when there is speculation over trends in the market. Trading options typically requires far less capital than stock trading. With this in mind, profit potential will be in most cases significantly less. This is because profit is based on the premium and bid price placed on the contract. The upside is that there is usually far less risk in trading options contracts.
It’s important to note that buyers are not obligated to exercise their contracts. Buyers will most often sell the contract prior to expiration for either a profit or loss. Some buyers will exercise options but most don’t.
Features of Option Contracts
Options contracts have a variety of features such as intrinsic value, contract size, strike price, the expiration date, premiums as well as a zero obligation buy or sell.
Intrinsic value: is the current stock price-call strike price. This is the current value the shares have on the stock market.
Contract size: is the size of an option is based on the multiplier of 100. For example, when buying an options contract, the premium price must be multiplied by 100 since we are purchasing 100 contracts. This is often referred to as a “unit of trade.”
Strike price: is the value you pick for the contract. It is also the amount of cash the options buyer is entitled to if the options contact is exercised
Expiration date: is the date the options contract expires. By this date the owner has the right to sell but not the obligation.
Premium: is the total an investor must pay to purchase the contract. Often the premium is more expensive for shares that have high volatility.
Zero obligation: is when the buyer of the stock has the right but not the obligation to sell shares. While the seller is obligated to buy the stock if the option is exercised.
What Is an Example of an Option Contract?
Let’s show an example standard/naked put. For this example, we believe XYZ company is set to plummet in market value within the next three months. The stock is currently trading around $65 a share. We decided to purchase an options contract with a strike price of $60.
If the market price of the stock is now trading at $62 a share, then the value of the put option we purchased would increase. We would then be able to sell the option contract and take profit.
But, What if We Owned 100 Shares of Stock?
In this scenario, the buyer is purchasing a put contract to later sell at a strike price that is worth more than the current stock price. We believe company XYZ is set to fall in price from $65 a share to $50.
For that reason, we purchased a put option. The put option has a strike price of $60, with a premium of $3.10 per share. Meaning, $3.10 multiplied by 100 equals our $310 premium. This price must be spent as this amount is what we used to hedge against a drop in market value. If the price drops to $50 a share, we would still have the ability to sell our 100 shares at $60 a share. This would allow us to only be out $810 instead of the potential loss of $1000. Options contracts can be a useful tool to use in one’s portfolio to hedge against market downfalls.
Types of Option Contracts
The two most common types of options contracts are calls and puts. A call gives the buyer the right to purchase stock, while the seller is obligated to sell the stock. While puts give buyers the right to sell stock, while sellers must purchase the stock.
Typically, all options are bought to give the investor leverage when it comes to price. They give investors the ability to purchase stock at a fraction of the current market price if exercised. Put options are similar but rise in value when the stock price is trading lower than the strike price.
What Are Call Option Contracts?
Call options contracts give the owner the ability to buy stock at a specified period of time at a set price. In this scenario, buyers are looking for specific stock that is set to increase in value. This is because, when the stock increases in value, the owner of the option now has the ability to purchase shares at a discounted price.
For example, if an investor decides to buy a call options contract to purchase stock for $4, with a premium price at $45 ($.45×100) at XYZ company and it increases to $5 before expiration. The owner will have the ability to either, execute an order and purchase those stocks at a discounted price. Or, sell at the bid price and take profits.
What Are Put Option Contracts?
Put options are a contract that gives buyers the right to sell a futures contract before the expiration date. Buyers will then need to buy a premium from the sellers of the options. While the options contract is at a set price, the premium will depend on the terms agreed upon by the two parties.
Those who own put options purchase them at a set price to sell while the buyer will agree to purchase at that set price. Those who buy and sell put options, are oftentimes rewarded in short periods, since the put can gain value quickly when the stock price falls. Once the put is sold the seller receives a premium, this is an attractive trade for those looking to make money quickly.
What Is an Option Spread?
Put options spreads are referred to as put verticals. This is because the strikes are vertical on option tables. With this, there is less risk and which means less growth potential. Those who purchase put spreads are looking to receive profit from the markets being bearish.
This strategy takes place when there is an equal number of put options being sold and purchased. Maximum profit potential is limited when using a put option spread strategy.
The Main Benefits of Option Contracts
Options trading has multiple benefits that can aid investors in achieving a variety of goals.
Risk management: When trading options buyers are exposed to far less risk than traditional stockholders.
Cheaper to enter trade: Investors are able to purchase stock at prices much lower than what they are currently valued at. The options contract gives the investor to buy or sell at the strike price made with any period before expiration.
Liquidity: Liquidity is how quickly a stock or option can be bought or sold. Options trades allow for trades to pull money out whenever they want. When a contract has high liquidity, the spread is thinner. Making it easier to buy and sell the contracts at the mid price, the price between the bid and the ask.
Leverage: Investors buying options rather than traditionally have a chance to accumulate more profit. This is because of the smaller upfront capital needed.
The Main Disadvantages of Option Contracts
Expiration deadline: Chances of having an options contract expire worthless is very high. Investors have to keep in mind the potentially high amounts that can be lost within options trading.
Profits taxed: Profits made through options contracts are typically taxed at short-term gains rate, which is much higher than traditional common stocks.
Lower profit potential: While trading options, profit is much lower than when trading traditional stocks. With managed risk, the chances of making unlimited profit on.
Not available on all stocks: Many stocks, especially OTC stocks, are not available to trade though options trading. While options trading does cover most stocks, investors may find many companies unavailable to trade.
What Is the Bottom Line?
Options can be a great investment tool for investors to employ when they have good grasp on the subject. Trading options allow for investors to make profits depending on the current market value.
Want to Start Trading Options?
Options trading is a useful tool that investors utilize in order to make profit. Before investing into options contracts, investors should do as much background research on the companies they are interested in. In order to make an options contract profitable, it’s important for investors to do their due diligence and research of the company and also the market.
Implementing option strategies can often expose investors to higher amounts of risk. A financial plan can help aid in investment choices. Learn how you can develop an effective financial plan to meet your goals by talking to a financial advisor.