What Is an Options Contract?
An options contract is a financial agreement that grants the buyer the right, but not the obligation, to buy or sell a particular asset (like a stock) at a preset price within a given period. As financial markets have grown increasingly complex and, at times, more volatile, options have emerged as a potent way to guard against uncertainty and capitalize on price changes. In just a couple of decades, options, with their ability to leverage gains, manage risk, and strategic flexibility, have moved from an esoteric tool for professionals into a mainstream vehicle.
From individual investors to large institutional players, many market participants use options for speculation, hedging, and generating income. The numbers tell the story: trading volume in options has increased by about 150% in the past decade and about 15-fold since 2000. The vast increase in options trading has been helped by a massive spike in retail investor interest, which peaked at almost 50% of all trading volume during the pandemic and has remained in the low 40s by percentage for most months since.1
Below, we take you through what you need to know about these contracts, how they work, who trades them and why, and the advantages and pitfalls to avoid should you add them to your trading strategy.
Key Takeaways
- Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at a preset price on or before a specific date.
- There are two main types of options: call options, which give the holder (buyer) the right to buy the underlying asset, and put options, which give the holder (buyer) the right to sell the underlying asset.
- Depending on your goals and risk tolerance, options contracts can be used for hedging, speculation, and generating income.
- The price of an option, known as the premium, is affected by the underlying asset’s price, the strike price, time until expiration, and market volatility.
- Options trading carries inherent risks, such as the potential for significant losses if the market moves against your position, and requires a thorough understanding of the mechanics and strategies involved.
Understanding Options Contracts
Options contracts are valued based on the underlying securities. These contracts allow the buyer to buy or sell—depending on the type of contract they hold—the underlying asset at a price set out in the agreement, either within a specific time frame or at the expiration date. The underlying assets include currencies, stocks, indexes, interest rates, exchange-traded funds, and more.2
The terms of option contracts specify the underlying security, the price at which that security can be bought or sold (the strike price), and the expiration date of the contract. For stocks, a standard contract covers 100 shares, but this number can be adjusted for stock splits, special dividends, or mergers.
Options are generally used for hedging purposes but can also be employed to speculate on price moves. The contracts generally cost a fraction of what the underlying shares would. Options can provide leverage, meaning that the premium allows you to be exposed to a larger position of shares for a fraction of the cost of buying the underlying security. In exchange for this right, the buyer of the option pays a premium to the party selling the option.
Options strategies are adaptable to various market conditions. Traders buy or sell options contracts based on whether they are bullish or bearish on the underlying asset, and they often use strategies that combine several options and long positions (owning the asset outright) at once.3
Types of Options Contracts
There are two types of options contracts: puts and calls. Both can be bought to speculate (to profit on price changes) or hedge exposure (that is, to insure positions you already have or may have). They can also be sold to generate income.4
In general, call options can be bought as a leveraged bet on the appreciation of a stock or index, while put options are purchased to profit from price declines. The buyer of a call option has the right, but not the obligation, to buy the number of shares covered in the contract at the strike price. Put buyers, meanwhile, have the right, but not the obligation, to sell the shares at the strike price specified in the contract.2
Option sellers, known as writers, are obligated to perform their side of the trade if the buyer decides to execute (or “assigns”) the call option and buy the underlying security or execute a put option to sell. Here’s how it occurs:
- Call option contract: In a call option transaction, a position is opened when a contract or contracts are bought from the seller. The seller is paid a premium to assume the obligation of selling shares at the strike price. The position is called a covered call if the seller holds the shares to be sold.
- Put option contract: Buyers of put options often speculate on price declines in the underlying asset and own the right to sell the shares at the strike price. If the share price drops below the strike price before or at expiration, the buyer can sell the shares to the option seller at the strike price or sell the contract if the shares are not held in the portfolio.
When trading volume or volatility is relatively low and the market is trending upward, traders often buy one or more calls since call options tend to appreciate in value as the underlying asset’s price rises. Meanwhile, traders tend to buy puts when volume or volatility is relatively low and the market is trending downward since puts increase in value when the market declines. During market downturns, option traders often sell calls, while they sell puts when the market is advancing.5
American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date.
Hedging and Speculating With Options Contracts
Options can be an effective tool for hedging as they allow investors to protect their investments against downside risk while retaining the possibility of upside gain. Typically, hedging involves taking an offsetting position in a related security, such as a call or put option. Suppose you’re a portfolio manager focusing on equities. You want to protect the portfolio from a potential downturn and might buy put options for the stocks on the portfolio. If stock prices fall, the put options will increase in value, offsetting the losses in the portfolio.
Options are also widely used for speculative purposes because of their inherent leverage. Since options allow you to control a large amount of a stock or other underlying asset through a relatively small premium, they can offer increased speculative prospects. Suppose you expect a company’s stock price will rise and buy call options. If the stock price increases beyond the strike price of the options, you earn a profit that is a multiple of the initial premium paid. On the other hand, if an investor believes a stock’s price is about to fall, they might buy put options. A drop in the stock price below the strike price can lead to significant gains relative to the initial premium.
Let’s put this idea of leverage into action. Suppose ABC stock trades at $100 per share. You think that the price is about to jump in the next month. You can do two things:
- Buy 100 shares of ABC stock at $100 per share. This would cost you $10,000 (100 shares × $100 per share).
- Buy one call option contract with a strike price of $100 and an expiration date one month from now. Let’s assume the premium (cost) of the option is $2 per share. Since each option contract is 100 shares, the total cost of the option would be $200 (100 shares × $2 per share).
Now, let’s fast forward one month and assume the stock price has risen to $120 per share. Congratulations, your analysis was correct. If you took the first choice above, you would profit $2,000 (less fees and taxes): ($120 – $100) × 100 shares.
