In the financial industry, an option is a contract that can be bought and sold on exchanges – the majority of securities option contracts are traded on the NYSE or the NASDAQ. For the most commonly traded options, the underlying investments are securities. An option contract entitles the owner to buy or sell 100 shares of a security at a designated price – called the strike price – before the contract expiration. This will make more sense as you read on.
Option Contracts: Call Contract
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The investor who purchases a call option contract is entitled to purchase 100 shares of a security at a certain, pre-determined price before the expiration. The terms of the call contract will specify the contract expiration and the strike price that the investor will pay for the security if he/she decides to exercise the option. Generally, the reason to purchase a call contract is to buy the right to purchase a security at a price that is lower than the market price. For example:
- Leon purchased a call contract that entitles him to buy Company XCV stock at $30 per share. The contract expires in 30 days.
- Leon believes Company XCV stock will increase in value beyond $30 per share before the expiration.
- If Company XCV stock reaches a higher price – say $40 per share – within 30 days, Leon can choose to exercise his option to purchase Company XCV stock at the $30 per share strike price. In this situation, Leon would be buying stock at a price that is cheaper ($30 per share) than the market price ($40 per share), so he could profit from selling the stock he purchased using his call contract.
- If Leon is incorrect, and the price of Company XCV stock does not go higher than $30 per share, he would not want to exercise his option to purchase Company XCV stock at a $30 per share strike price. Paying the strike price would mean buying stock at a price higher than market value (paying more than it is worth). In this situation, Leon would simply lose the money he spent purchasing an unused call contract.
Call contract sellers benefit when price of the security goes down and the option is not exercised. Some financial companies that sell call contracts calculate mathematical probabilities associated with option contracts, and they hedge call contracts with put contracts and vice versa.
Option Contracts: Put Contract
The investor who purchases a put option contract is entitled to sell 100 shares of a security at a certain, pre-determined price within a particular time frame. The terms of a put contract will specify the expiration and the strike price at which the contract owner can sell the security if he/she decides to exercise the option. Two common reasons to purchase a put contract are (1) to buy the right to sell a security at a price that is higher than the market price, or (2) to protect stock that an investor has purchased. Here is an example of reason (1):
- Sherrie purchased a put contract that entitles her to sell Company ABC stock at a $50 per share strike price. The contract will expire in 60 days.
- Sherrie believes that the Company ABC stock she just purchased at $50 per share could go up or down in value. Purchasing a put option contract has allowed Sherrie to hedge against a possible decline.
- If Sherrie’s concerns become reality, and Company ABC stock drops to $40 per share, Sherri has purchased the right to sell her shares at the $50 per share strike price. In this situation, since Sherrie purchased the stock at $50 per share, her only loss is the money she paid for the put contract.
- If Sherrie’s concerns are unwarranted, and Company ABC stock gains value, Sherrie would not exercise her option because she could sell her stock at a rate higher than the strike price. In this situation, Sherrie would simply lose the money she spent on an unused put contract.
Put contract sellers benefit when the price of the security goes higher than the put contract strike price and the option is not exercised.
Trading in Options
Trading options can be relatively simple (the examples above are simple) or extremely complicated. Frequent and experienced traders employ advanced tactics like options spreads, short-selling and (if properly licensed) even trading options on international exchanges.
Brokerage houses generally require extensive background information and verification about traders who wish to engage in advanced options trading. Anyone could be eligible to buy or sell simple option contracts through a brokerage house. Paperwork and documentation are required, and sometimes an investor’s history or financial situation precludes eligibility. Investors also can be limited by the rules of their brokerage accounts.