Definition of an Options Contract
The best way to begin our introduction to options trading is to define exactly what options are. Although commonly referred to simply as options, the full term is options contracts, because they are financial contracts between two parties. In very basic terms, they specify a future transaction on a specified asset at a specified price.
The buyer of the contract has the right, but not the obligation, to initiate that specified transaction. The seller of the contract has the related obligation to carry out the transaction should the holder choose to initiate it.
There are several characteristics of options that essentially make up the terms for any given contract. The easiest way to define an options contract is to identify those characteristics and explain what they are. We have done exactly that below, and we have also provided some example options to give a clear idea of what they are and how they work.
An options contract consists of two parties: the holder and the writer. The writer is effectively the seller of the contract, while the holder is effectively the buyer. When the writer of the contract sells it to the buyer, they collect a payment from the buyer and that's commonly referred to as the premium.
It's the holder of the contract that has the option to engage in the transaction that is specified and the writer that is obliged to engage in the transaction should the holder wish to go ahead. If the holder chooses to initiate the transaction specified in the contract, they are said to be exercising their option. Should the holder not choose to exercise their option at any point, then the contract will eventually expire and cease to exist.
You can read more about exercising an option here.
Options are a form of derivative; which basically means they derive their value from an underlying asset. In an options contract the underlying asset is the asset which is specified in the transaction the holder has the right to carry out.
For example, a contract might give the holder the right to purchase stock in Company X, in which case Company X stock is the underlying asset. The term underlying security is also commonly used, but both terms refer to the same thing.
There's a range of financial instruments that can be the underlying asset in an option. Stock is the most commonly used asset, but bonds, indices, foreign currencies, commodities, or futures can all be used too. There are even basket options, in which the underlying asset is a collection of different assets.
The strike price is the price at which the specified transaction is to be carried out at should the holder choose to exercise their option. For example, an options contract that gives the holder the right to purchase stock in Company X might have a strike price of $50. The holder therefore has the right to purchase that stock from the writer at $50, regardless of what the actual trading price of that stock is at the time.
Strike price is the term most commonly used, but it can also be known as the exercise price.
The expiration date of an option is, quite simply, the date on which the contract will expire. Options are typically relatively short term and last just a few weeks, although they can also last for a few months or up to a year. If the expiration date passes and the holder hasn't chosen to exercise their option, then the contract expires worthless.
There are actually many different types of options, because they can be classified in a variety of different ways. In a very broad sense though, they can be categorized based on whether they give the holder the right to buy or sell the underlying asset. In this sense, there are basically two main types; call options which give the holder the right to buy the underlying asset at the strike price, and put options which give the holder the right to sell the underlying asset at the strike price.
It should be noted that you don't have to actually own any of the underlying asset to buy a put option, but if you choose to exercise your option to sell the underlying asset you will, in theory, have to buy the underlying asset at that point.
Please see our section on the Types of Options for further details on this.
Another way that options can be categorized is based on their exercise style. They can basically be one of two styles: American style or European style. These terms have nothing to do with anything geographical though.
An American style option is one where the holder can exercise their option at any time during the term of the contract, up to and including the date of expiration. A European style option is one where the holder can only exercise their option, should they wish to, at the point of expiration. American style options clearly offer much more flexibility to the holder, and because of this they are generally more expensive to buy.
When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place. They are physical settlement and cash settlement.
Physical settlement is where the underlying asset is actually transferred between the buyer and the holder at the agreed strike price. For example, if the holder of a call option based on Company X stock, with a strike price of $50, chose to exercise their option then they would physically purchase Company X stock at the price of $50 per share.
Cash settlement is where the holder receives a cash payment based on any profit they could effectively make through exercising their option. If the above example was a cash settled option, and stock in Company X was actually trading at $55, then the holder would receive a $5 payment per contract owned at the time of settlement. The $5 represents the profit the holder could make by buying the stock at $50 and selling it at the trading price of $55.
Please see Options Settlement for more details.
Bid and Ask Price
When the writer of an options contract sells it to a buyer, the buyer makes a payment in order to purchase it. However, the amount that the buyer pays isn't the same amount that the writer receives.
Options are typically bought and sold on the public exchanges, where the transactions are facilitated by market makers. They basically exist to ensure that there's always a market for options contracts. If someone wishes to sell, and there is no buyer, then the market maker will act as the buyer and complete the necessary transaction. If someone wishes to buy, but there is no seller, then the market maker will act as the seller.
Market makers make a small profit on each transaction. Options contracts are listed on the exchanges with two prices: the bid price and the higher ask price. The bid price is the price you would receive for writing options contracts, and the ask price is the price you would pay for buying them.
It's important to note that options contracts aren't just sold to buyers at the time of being written; holders of existing options contracts can also sell them to other buyers. Again, the seller would receive the bid price and the buyer would pay the ask price.
You can read more about the price of options here.
Examples of Options Contracts
To help you fully understand what an options contract is we have provided a couple of examples below, featuring some different characteristics.
Underlying Asset: Stock in Company X
Strike Price: $50
Expiration Date: 30th April 2013
Option Type: Call Option
Option Style: American Style
Settlement: Physical Settlement
Bid Price: $1.00
Ask Price: $1.20
If you were to write the above contract, you would be granting the holder the right to buy Company X stock at $50 at any time up to April 30th, 2013. The holder could exercise their option at any time because it's an American style options contract. If the holder did choose to exercise their option you would be obliged to sell them Company X stock at $50, regardless of what price the stock was trading at.
If you didn't own the relevant stock, you would have to first buy it and then sell it on to the holder. For every such contract written and sold, you would receive the bid price of $1.00. If the holder chose not to exercise their option by the expiration date, then it would expire worthless and your obligation would cease.
If you were to buy the above contract, you would have the right, but not the obligation, to buy Company X stock at $50 at any time up to April 30th, 2013. If you chose to exercise your option, you would pay $50 per share and would then physically own the stock.
You would obviously only exercise your option if the stock was trading at a price higher than $50, so you would be able to immediately sell your stock at a profit if you wanted. Alternatively, you could hold on to the stock if you preferred. You would pay the ask price of $1.20 for every contract you bought. If you chose not to exercise your option by the expiration date, your contract would expire worthless.
Underlying Asset: Stock in Company Y
Strike Price: $25
Expiration Date: 30th May 2013
Option Type: Put Option
Option Style: European Style
Settlement: Cash Settlement
Bid Price: $1.50
Ask Price: $1.75
If you were to write the above options contract, you would be granting the holder the right to sell you Company Y stock at $25 on May 30th, 2013. The holder could only exercise their option at that point as it is a European style option.
Cash settlement options are typically settled automatically if the holder is effectively in profit. If Company Y stock was trading at, say, $20 at the point of expiration, then the holder would theoretically be able to buy the stock at $20 and sell it to you at $25 for a $5 profit. In that scenario, the cash settlement would cost you $5 per contract written. If the stock was trading at $25 or higher, then the contract would expire worthless. You would receive the bid price of $1.50 for every contract written.
If you were to buy the above options contract, you would have the right, but not the obligation, to sell the writer of Company Y stock at $25 on May 30th, 2013. As a cash settlement option, you could expect it to be automatically exercised if you were in profit.
If Company Y stock was trading at, say, $15 at the point of expiration, you would effectively be in profit by $10. You would receive a cash settlement from the writer of the contract of $10 for every contract you owned. If the stock was trading at $25 or higher, then there would be no benefit in exercising your option and the contract would expire worthless.