Options contracts

What Are Options Contracts?

Options contracts are a type of derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined strike price on or before a specific expiration date. For this right, the buyer pays a non-refundable amount called a premium to the seller. These financial instruments belong to the broader category of derivatives, which derive their value from the performance of an underlying asset such as stocks, bonds, commodities, or indexes. Options contracts provide investors with flexibility for various strategies, including speculation and hedging against potential market movements.

History and Origin

The concept of options contracts can be traced back to ancient times, with early forms mentioned by Aristotle involving a philosopher named Thales who used a similar arrangement to secure olive presses. However, the modern, standardized options market began much more recently. A pivotal moment occurred with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. Prior to this, options were primarily traded over-the-counter with non-standardized terms. The CBOE revolutionized the market by introducing standardized contracts, which facilitated greater liquidity and transparency. The CBOE, founded by the Chicago Board of Trade, became the first exchange to list standardized, exchange-traded stock options, opening for trading on April 26, 1973.⁸,

Key Takeaways

• Options contracts grant the holder the right, but not the obligation, to buy or sell an underlying asset.
• The two primary types are call options (right to buy) and put options (right to sell).
• Options have a fixed strike price and an expiration date, after which they become worthless.
• They offer leverage, potentially amplifying gains but also losses relative to the initial premium paid.
• Options are commonly used for speculation, income generation, and risk management strategies.

Formula and Calculation

The valuation of options contracts is complex, with the most widely recognized method being the Black-Scholes-Merton (BSM) model, often simply referred to as the Black-Scholes model. Developed in 1973 by Fischer Black, Myron Scholes, and Robert Merton, this mathematical model provides a theoretical estimate of the price of European-style options.,⁷ The model considers several key inputs to determine an option's fair value:

$C = S_0 N(d_1) - K e^{-rT} N(d_2)$
$P = K e^{-rT} N(-d_2) - S_0 N(-d_1)$

Where:

• (C) = Theoretical call option price
• (P) = Theoretical put option price
• (S_0) = Current price of the underlying asset
• (K) = Strike price of the option
• (T) = Time to expiration date (in years)
• (r) = Risk-free interest rate
• (\sigma) = Volatility of the underlying asset's returns
• (N(x)) = Cumulative standard normal distribution function
• (e) = Euler's number (approximately 2.71828)
• (d_1 = \frac{\ln(S_0/K) + (r + \sigma^2/2)T}{\sigma\sqrt{T}})
• (d_2 = d_1 - \sigma\sqrt{T})

The Black-Scholes model helps in understanding how various factors influence the premium of an options contract.⁶

Interpreting the Options Contract

Interpreting an options contract involves understanding its key components and how they relate to the underlying asset's price movements. A call option gains value when the underlying asset's price rises above the strike price, while a put option gains value when the underlying asset's price falls below the strike price. The option's price is composed of two main parts: intrinsic value and time value. Intrinsic value is the immediate profit if the option were exercised (e.g., for a call, it's the stock price minus the strike price, if positive). Time value is the portion of the option's premium that exceeds its intrinsic value, reflecting the possibility that the option will gain more intrinsic value before expiration due to future price movements of the underlying asset. This time value erodes as the option approaches its expiration date, a phenomenon known as time decay.

Hypothetical Example

Consider an investor, Alice, who believes that Company XYZ's stock, currently trading at $100 per share, will increase in price over the next three months. To act on this belief without buying the shares outright, Alice decides to purchase a call option.

She buys one call option contract for XYZ with a strike price of $105, expiring in three months, for a premium of $3.00 per share. Since one options contract typically represents 100 shares of the underlying asset, her total cost for the contract is $3.00 * 100 = $300.

Scenario 1: Company XYZ's stock rises to $115 per share by the expiration date.
Alice's call option is "in the money" because the stock price ($115) is above her strike price ($105). She can exercise her right to buy 100 shares at $105 each and immediately sell them in the market at $115.
Profit per share: $115 (market price) - $105 (strike price) = $10.00
Gross profit: $10.00 * 100 shares = $1,000
Net profit: $1,000 (gross profit) - $300 (premium paid) = $700.

Scenario 2: Company XYZ's stock falls to $95 per share by the expiration date.
Alice's call option is "out of the money" because the stock price ($95) is below her strike price ($105). It would not be rational to exercise the option and buy shares at $105 when she can buy them for $95 in the open market. The option expires worthless.
Net loss: $300 (premium paid). This illustrates the limited downside risk for the option buyer (loss is capped at the premium) but also the potential for total loss of the premium.

Practical Applications

Options contracts are versatile financial instruments used by investors for a range of purposes in investing, markets, analysis, and portfolio planning. A primary application is hedging, where investors use options to protect existing portfolios from adverse price movements. For example, owning put options can act as a form of insurance against a decline in the value of shares held. Another significant use is speculation, allowing traders to profit from anticipated movements in the underlying asset with significant leverage. Options also feature in income-generating strategies, such as selling covered calls against owned stock to earn premiums.

Regulatory bodies actively oversee options trading to ensure fair and orderly markets and protect investors. The Chicago Board Options Exchange (Cboe), for instance, has its own regulations, including rules aimed at preventing manipulative behavior like spoofing and layering.⁵ The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) also play key roles in regulating options markets in the U.S., establishing rules for brokers and trading practices.,⁴ Effective risk management is crucial when engaging with options due to their inherent complexity and leverage.

Limitations and Criticisms

Despite their utility, options contracts come with inherent limitations and criticisms. One of the most significant drawbacks is their complexity, which can be challenging for inexperienced investors to fully grasp. Understanding concepts like the "Greeks" (delta, gamma, theta, vega), which measure an option's sensitivity to various factors, requires considerable study. The inherent leverage in options, while offering amplified gains, also magnifies potential losses, often leading to the total loss of the premium paid. All options contracts have an expiration date, and if the underlying asset does not move as expected before this date, the option can expire worthless, resulting in a complete loss for the buyer. This time decay (theta) is a constant drag on an option's value.

Furthermore, options markets can sometimes suffer from illiquidity for certain contracts, especially those far out of the money or with distant expiration dates, making it difficult to exit positions at favorable prices. The Financial Industry Regulatory Authority (FINRA) highlights several risks associated with options, including assignment risk for sellers, dividend risk, and margin risk.³ FINRA also cautions investors about potential fraudulent schemes related to options trading, such as account takeovers and new account fraud, particularly given the leverage and various series available in options.² Due diligence on the part of investors and brokerage firms is critical to mitigate these risks.¹

Options Contracts vs. Futures Contracts

While both options contracts and futures contracts are types of derivatives that allow investors to speculate on or hedge against the price movements of an underlying asset, a fundamental difference lies in the obligation they impose.

This distinction is crucial for investors in managing their exposure and defining their risk management strategies.

FAQs

What is the primary difference between a call option and a put option?

A call option gives the holder the right to buy an underlying asset at a specified strike price, while a put option gives the holder the right to sell the underlying asset at a specified strike price. Calls are typically bought when an investor expects the price to rise, and puts are bought when an investor expects the price to fall.

How does time affect an options contract's value?

As an options contract approaches its expiration date, its time value erodes. This is known as "time decay" or "theta decay." The closer an option is to expiration, the less time there is for the underlying asset to move favorably, thus reducing the option's value.

Can I lose more than my initial investment when trading options?

If you are an options buyer (long a call or put), your maximum loss is typically limited to the premium you paid for the contract. However, if you are an options seller (short a call or put, especially "uncovered" or "naked" options), your potential losses can be theoretically unlimited, depending on the movement of the underlying asset. This highlights the importance of understanding risk management before trading.