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
- 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 risk in the event price decreases because at most he can lose is the option premium. Similarly, the put option 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.
- 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.
Types & Examples of Option Contract
#1 – Call Option
It gives the owner the right to buy an underlying asset at a strike price 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.
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- Long Call Payoff Per-Share = [MAX (Stock Price – Strike Price,0) – Upfront Premium Per Share
- Case 1: if the stock price at expiration is $7920 the option will be exercised and the holder will buy it @ $7820 and sell it immediately in the market for $7920 realizing a gain of $100 considering upfront premium paid of $50, the net profit is $50.
- Case 2: if the stock price at expiration is $7700 the option holder will choose not to exercise as there is no point in buying it at $7820 when the market price of the stock is $7700. Considering the upfront premium of $50, the net loss is $50.
#2 – Put Option
It gives the owner the right to sell an underlying asset ta strike price at the expiration date. The put owner is bearish (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.
- Long Put Payoff Per-Share = [MAX (Strike Price – Stock Price, 0) – Upfront premium Per Share
- Case 1: if the stock price at expiration is $7300 the investor will buy the asset in the market at $7300 and sell it under the terms of put option @7550 to realize a gain of $250. Considering the upfront premium paid $50 the net profit is $200.
- Case 2: if the stock price at expiration is $7700 the put option expires worthless and the investor loses $50 which is the upfront premium.
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
- Exchange-Traded Options have standardized features with respect to expiration dates, contract size, strike price, position limits and exercise limits and are traded in an exchange where there is minimum default risk.
- Over the Counter, Options can be tailored by private parties to meet their particular needs. Since there are privately negotiated option writer may default on its obligation. Post-1980 over the counter market is much larger than the exchange-traded market.
- The option can be either American or European: American option can be exercised at any time up to expiration date whereas European option can only be exercised on expiration date itself. Most of the option traded in the exchange are European option there are easier to analyze than American option.
Drivers of the Option Contract Value
- 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.
- 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
- 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.
- 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 flows 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.
- There are two types of options: call which gives the holder the right to buy an underlying asset for a certain price by a certain date. A put option gives the holder the right to sell the underlying asset at a certain date for a certain price.
- There are four possible positions in options markets: a long call, a short position in the call, a long position input, and a short position input. Taking a short position in an option is known as writing it.
- An exchange must specify the terms of the options contracts it trades. It must specify the contract size, expiration time and the strike price whereas Over the counter trades are customized between private parties to meet their specific requirements.
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 –