Option Contract

Option Contract Definition

An option contract is an agreement that gives the option holder the right to buy or sell the underlying asset at a certain date (known as expiration date or maturity date) at a prespecified price (known as strike price or exercise price) whereas the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.

There are 2 Parties to the Contract

  1. Option Holder or Buyer of the Option: It pays the initial cost to enter into the agreement. The call option buyer benefits from price increase but has limited downside riskDownside RiskDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. read more in the event price decreases because at most he can lose is the option premium. Similarly, the put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more buyer benefits from price decrease but has limited downside risk in the event when price increases. In short, they limit the investor’s downside exposure while keeping the upside potential unlimited.
  2. Option Seller or Writer of the Option: It receives the premium at the initiation of the option contract to bear the risk. The call writer benefits from Price decrease but has unlimited upside risk in case price increases. Similarly put writer benefits if price increases as he will keep the premium but may lose a considerable amount of price decrease.

Options are currently traded on stock, stock indices, futures contracts, foreign currency, and other assets.

Option-Contract

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Types & Examples of Option Contract

#1 – Call Option

Long Call Strategy

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It gives the owner the right to buy an underlying asset at a strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more at the expiration date. The call owner is bullish (expects the stock price to rise) on the movement of the underlying assets. Let’s take an example Consider an investor who buys the call option with a strike of $7820. The current price is $7600, the expiration date is in 4 months and the price of the option to purchase one share is $50.

#2 – Put Option

Long Put Strategy

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It gives the owner the right to sell an underlying asset ta strike price at the expiration date. The put owner is bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more (expects the stock price to fall) on the movement of the stock price. Let’s take an example Consider an investor who buys the put option with a strike of $7550. The current price is $7600, the expiration date is in 3 months and the price of the option to purchase one share is $50.

Uses of Option Contracts

#1 – Speculation

The investor takes an option position where he believes that the stock price is currently selling at a lower price but can considerably rise in the future leading to profit. Or in case he believes the market price of a stock is selling at a higher price but can fall in the future leading to profit. They are betting on the future direction of the market variable.

#2 – Hedging

The investor already has an exposure to the asset but use option contract to avoid the risk of an unfavorable movement in the market variable.

Option Contracts are Exchange Traded or Over the Counter

Drivers of the Option Contract Value

  1. The volatility of the underlying stock: Volatility is a measure of how uncertain we are about future price movements. As volatility increases the chance of stock to appreciate or depreciates in value increases. The higher the stock volatility the greater the value of the option.
  2. Time to Maturity: The more the time left to expiration the greater the values of option. Longer maturity option is valuable as compared to shorter maturity contract
  3. The direction of underlying stock: If the stock appreciates, it will have a positive impact on the call option and negatively impact put options. If the stock falls it will have the opposite effect.
  4. Risk-free rate: As the interest rate increases the expected return required by investors tends to increase. In addition, while discounting the future stream of cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more to present value using a higher discount rate results in a decrease in the option value. The combined effect increases the value of the call option and decreases the value of the put option.

Advantages of Option Contract

  • Provide Insurance: Investors can use Option contracts to protect themselves against adverse price movement while still allowing them to benefit from favorable price movement.
  • Lower Capital Requirement: Investors can take exposure to stock price by just paying an upfront premium which is much lower than the actual stock price.
  • Risk/Reward Ratio: Some strategies allow the investor to book considerable profit while the loss is limited to the premium paid.

Disadvantages of Option Contract

  • Time Decay: When buying option contract time value of the options diminishes as maturity approaches.
  • Involves Initial Investment: Holder is required to pay an upfront nonrefundable premium which it can lose if the option is not exercised. During volatile markets, option premium associated with the contract can be quite high.
  • Form Leverage: Option contract is a double-edged sword. It magnifies financial consequences that can result in huge losses if the price does not move as expected.

Conclusion

This has been a guide to What is an Option Contract and its Definition. Here we discuss option contract types and contract options that are traded in exchange or over the counter along with advantages and disadvantages. You can learn more about excel modeling from the following articles –

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