Skip to main content
diversification.com
← Back to O Definitions

Option contract

<div style="display: none;">

LINK_POOL

</div>

What Is an Option Contract?

An option contract is a financial derivative that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific expiration date. As a type of derivatives instrument, its value is derived from the price movements of the underlying asset, which can range from stocks and bonds to commodities or currencies. Investors utilize option contracts for various purposes, including hedging existing positions, engaging in speculation on future price movements, or generating income through the collection of premiums.

History and Origin

While informal options-like agreements have existed for centuries, the modern, standardized option contract as traded today traces its roots to the establishment of the Chicago Board Options Exchange (CBOE). Before the CBOE, options were primarily traded in an over-the-counter (OTC) market, characterized by non-standardized terms and direct buyer-seller links. The concept of an organized exchange for options began to formalize in the late 1960s, driven by figures like Edmund O'Connor of the Chicago Board of Trade (CBOT).12

On April 26, 1973, the CBOE opened its doors as the first marketplace dedicated to trading standardized option contracts.11,10 This innovation allowed for greater liquidity, transparency, and accessibility for investors, as contracts had uniform terms and a central clearinghouse stood behind the trades.9 The introduction of standardized call option contracts in 1973 was followed by put option contracts in 1977, further expanding the market's offerings and solidifying the option contract as a significant tool in the financial markets.8

Key Takeaways

  • An option contract grants the buyer the right, but not the obligation, to execute a transaction involving an underlying asset.
  • The contract specifies a strike price at which the transaction can occur, and an expiration date by which it must be exercised.
  • Buyers pay a non-refundable premium to the seller (writer) for this right.
  • Option contracts are versatile tools used for hedging existing investments, generating income, or speculating on market direction.
  • Understanding the risks, particularly for option sellers, is crucial due to potential for significant losses.

Formula and Calculation

The premium of an option contract is the price paid by the buyer to the seller for the rights conveyed by the contract. While complex models like Black-Scholes are used by professionals, the premium itself is influenced by several key factors:

Premium=f(Underlying Price,Strike Price,Time to Expiration,Volatility,Interest Rates,Dividends)\text{Premium} = f(\text{Underlying Price}, \text{Strike Price}, \text{Time to Expiration}, \text{Volatility}, \text{Interest Rates}, \text{Dividends})

Where:

  • (\text{Underlying Price}): The current market price of the underlying asset.
  • (\text{Strike Price}): The predetermined price at which the option can be exercised.
  • (\text{Time to Expiration}): The remaining time until the expiration date of the option. Options with more time typically have higher premiums.
  • (\text{Volatility}): The expected fluctuation of the underlying asset's price. Higher expected volatility generally leads to higher premiums.
  • (\text{Interest Rates}): Prevailing interest rates, which can impact the cost of carrying the underlying asset.
  • (\text{Dividends}): Any expected dividends from the underlying asset.

Interpreting the Option Contract

Interpreting an option contract involves understanding its components and what they imply for potential profit or loss. For a call option, the buyer profits if the underlying asset's price rises above the strike price plus the paid premium before expiration. Conversely, a put option buyer profits if the underlying asset's price falls below the strike price minus the premium.

The relationship between the underlying asset's price and the option's strike price determines if an option is "in-the-money," "at-the-money," or "out-of-the-money." An option's "moneyness" is critical for assessing its intrinsic value and likelihood of profitable exercise. The time value, which decays as the expiration date approaches, also plays a significant role in an option's overall value.

Hypothetical Example

Consider an investor, Alice, who believes Stock XYZ, currently trading at $50 per share, will rise in the next three months. She decides to buy a call option contract on Stock XYZ.

  • Underlying Asset: Stock XYZ
  • Strike Price: $55
  • Expiration Date: Three months from now
  • Premium: $2.00 per share (or $200 for a standard 100-share contract)

Alice pays $200 for this call option.

Scenario 1: Stock XYZ rises to $60 before expiration.
Alice can exercise her option to buy 100 shares of XYZ at $55 per share, even though the market price is $60. She then sells the shares at $60.

  • Cost of buying shares: $55 * 100 = $5,500
  • Revenue from selling shares: $60 * 100 = $6,000
  • Gross profit from exercise: $6,000 - $5,500 = $500
  • Net profit (after premium): $500 - $200 = $300

Scenario 2: Stock XYZ stays at $50 or falls.
If Stock XYZ does not rise above $55, or if it doesn't rise enough to cover the premium, Alice will likely let the option expire worthless. Her maximum loss is limited to the premium paid, which is $200. This illustrates a key characteristic of option contracts for buyers: limited downside risk.

Practical Applications

Option contracts are integral to various financial strategies across investing, risk management, and market analysis. They offer flexible tools for market participants ranging from individual investors to large institutions.

One common application is hedging. For instance, an investor holding a stock portfolio might buy put option contracts on those stocks or an index to protect against potential declines in value. This strategy provides a form of insurance, limiting potential losses while allowing the investor to benefit from upward movements.

Conversely, option contracts are widely used for speculation. Traders might buy call options if they anticipate an increase in the price of an underlying asset or buy put options if they expect a decrease. Options can offer significant leverage, meaning a small movement in the underlying asset's price can lead to a proportionally larger profit or loss on the option.

Furthermore, option contracts are employed for income generation. Sellers (or "writers") of options collect the premium from buyers. If the option expires worthless (unexercised), the seller keeps the entire premium as profit. This can be a strategy for investors looking to generate additional income from their holdings, though it carries distinct risks. The growth in the use of derivative instruments, including options, has been significant in both mature and emerging financial markets.7

Limitations and Criticisms

Despite their versatility, option contracts come with significant limitations and criticisms, particularly concerning the level of risk management required. For option buyers, the primary limitation is the rapid decay of an option's time value as the expiration date approaches. If the underlying asset does not move as anticipated, the entire premium paid can be lost.6

For option sellers, the risks can be substantially higher. While a seller collects a premium, the potential loss can be unlimited for certain types of calls if the underlying asset's price rises dramatically, or substantial for puts if the underlying asset's price falls significantly.5 This asymmetry of risk, where the buyer's loss is limited to the premium but the seller's can be far greater, necessitates careful consideration.

The complexity of options strategies and the leverage they offer also pose challenges, especially for individual investors. The Securities and Exchange Commission (SEC) emphasizes that options trading entails significant risk and is not appropriate for all investors, noting that losses can rapidly exceed the initial investment.4,3 Recent trends, such as the increase in "zero days to expiry" (0DTE) option contracts, highlight these concerns, as these contracts are highly sensitive to intraday market moves and can expose sellers to increased risk of large losses.2 Effective portfolio diversification strategies typically involve a thorough understanding of these inherent risks.

Option Contract vs. Futures Contract

Both the option contract and the futures contract are types of derivatives that derive their value from an underlying asset and involve an agreement to trade that asset at a predetermined price on a future date. However, a fundamental difference lies in the obligation they impose. An option contract grants the buyer the right, but not the obligation, to buy or sell the underlying asset. The option holder can choose to exercise the option or let it expire worthless. In contrast, a futures contract is a standardized agreement to buy or sell an asset at a set price on a future date, and both parties are obligated to fulfill the contract at expiration. Futures contracts are typically marked to market daily, meaning gains and losses are settled daily, whereas an option buyer's financial commitment is limited to the initial premium paid.

FAQs

Q1: What is the main difference between buying a call option and buying a put option?

A: Buying a call option gives you the right to buy the underlying asset at a specific price, typically because you expect its value to increase. Buying a put option gives you the right to sell the underlying asset at a specific price, usually because you expect its value to decrease.

Q2: What is a premium in the context of an option contract?

A: The premium is the price the buyer pays to the seller for an option contract. It's the cost of acquiring the right to buy or sell the underlying asset and is non-refundable.

Q3: Do I need a special type of brokerage account to trade option contracts?

A: Yes, typically, you need a brokerage account approved for options trading. Brokers require investors to complete an options agreement, providing information about their trading experience, financial situation, and investment objectives to determine suitability for options trading.1