What Is an Options Contract?
An options contract is a financial instrument that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, called the strike price, on or before a specified date, called the expiration date.
How Do Options Contracts Work?
To buy an options contract, the buyer pays a premium to the seller, who is obligated to fulfill the terms of the contract if the buyer decides to exercise their option. The premium amount is determined by various factors, including the current price of the underlying asset, the strike price, the expiration date, and the level of volatility in the market.
If the buyer of a call option decides to exercise their option, they buy the underlying asset at the strike price from the seller. If the buyer of a put option decides to exercise their option, they sell the underlying asset at the strike price to the seller.
If the buyer decides not to exercise their option before the expiration date, the option contract expires worthless and the buyer loses the premium they paid for the option.
Types and Styles of Options Contracts
Options contracts can be categorized into two main types:
- Call Options:
A call option gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (the strike price) on or before a specified date (the expiration date). If the price of the underlying asset rises above the strike price before the expiration date, the holder can exercise their option and buy the asset at the lower strike price, making a profit.
For example, suppose an investor believes that the price of XYZ stock, currently trading at $50 per share, will rise in the next month. They could purchase a call option with a strike price of $55 and an expiration date one month from now. If the price of XYZ stock rises above $55, the investor can exercise their option and buy the stock at the lower strike price, then sell it on the open market at the higher price, making a profit. If the price of XYZ stock remains below $55, the investor can simply let the option expire and only lose the premium paid for the option.
- Put Options:
A put option gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price (the strike price) on or before a specified date (the expiration date). If the price of the underlying asset falls below the strike price before the expiration date, the holder can exercise their option and sell the asset at the higher strike price, making a profit.
For example, suppose an investor owns 100 shares of ABC stock, currently trading at $80 per share, and wants to protect against potential losses if the stock price falls. They could purchase a put option with a strike price of $75 and an expiration date one month from now. If the price of ABC stock falls below $75, the investor can exercise their option and sell the stock at the higher strike price, protecting against further losses. If the price of ABC stock remains above $75, the investor can simply let the option expire and only lose the premium paid for the option.
On the other hand, options contracts can also be classified into two main styles:
- American Style Options:
These are options contracts that can be exercised by the buyer at any time before the expiration date of the contract. American-style options are more flexible, which means that American-style options have a higher premium compared to their European counterparts.
- European Style Options:
These are options contracts that can only be exercised by the buyer at the expiration date of the contract. European-style options are less flexible, which means that European-style options have a lower premium compared to their American counterparts.
While the types of options refer to the right to buy or sell the underlying asset, the styles of options refer to when the option can be exercised. In general, the majority of options traded on U.S. exchanges are American-style options, but there are also many European-style options available for trading as well.
Common Options Trading Strategies
Basic Options Strategies
A basic, or single-leg, options trade involves buying or selling a single options contract on an underlying asset, without combining it with any other options contracts.
Here is a list of basic options strategies:
- Buying a Call Option: This strategy involves buying a call option, which gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (strike price) within a specific time frame (expiration date). This strategy can be used when the trader expects the price of the underlying asset to rise.
- Buying a Put Option: This strategy involves buying a put option, which gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price within a specific time frame. This strategy can be used when the trader expects the price of the underlying asset to fall.
- Selling a Call Option: This strategy involves selling a call option, which obligates the seller to sell an underlying asset at a predetermined price within a specific time frame if the buyer exercises the option. This strategy can be used when the trader expects the price of the underlying asset to remain stable or decline.
- Selling a Put Option: This strategy involves selling a put option, which obligates the seller to buy an underlying asset at a predetermined price within a specific time frame if the buyer exercises the option. This strategy can be used when the trader expects the price of the underlying asset to remain stable or rise.
- Covered Call: This strategy involves buying an underlying asset and selling a call option on that asset. The sale of the call option generates income for the trader, but if the price of the underlying asset rises above the strike price, the trader may be obligated to sell the asset at a loss.
- Protective Put: This strategy involves buying an underlying asset and buying a put option on that asset. The put option provides downside protection in case the price of the underlying asset falls.
Advanced Options Strategies
An advanced, or multi-leg, options trade involves trading multiple options contracts simultaneously to create a more complex position. This type of trade can be used to create a range of different payoff scenarios, depending on the trader’s objectives and market outlook.
Here is a list of advanced options strategies:
- Butterfly Spread: This involves buying one call option with a lower strike price, selling two call options with a middle strike price, and buying one call option with a higher strike price. This strategy is used when the trader believes that the underlying asset will remain within a narrow range.
- Iron Butterfly: This is similar to the butterfly spread, but it involves selling both a call option and a put option at the same strike price, and buying both a call option and a put option at a higher and lower strike price respectively. This creates a limited profit and limited loss scenario.
- Straddle: This involves buying both a call option and a put option with the same strike price and expiration date. It’s used when the trader believes that the underlying asset will experience a significant price movement, but is uncertain of the direction of the movement.
- Strangle: This is similar to the straddle, but it involves buying a call option and a put option with different strike prices. This strategy is used when the trader believes that the underlying asset will experience a significant price movement, but is uncertain of the direction of the movement.
- Condor: This involves buying a call option with a higher strike price, selling a call option with an even higher strike price, selling a put option with a lower strike price, and buying a put option with an even lower strike price. This creates a limited profit and limited loss scenario.
- Diagonal Spread: This involves buying a longer-term call option with a lower strike price, and selling a shorter-term call option with a higher strike price. This strategy is used when the trader believes that the underlying asset will experience a gradual upward trend.
- Iron Condor: This involves buying a call option with a higher strike price, selling a call option with an even higher strike price, selling a put option with a lower strike price, and buying a put option with an even lower strike price. This creates a limited profit and limited loss scenario, similar to the Condor strategy, but with a more narrow range.
- Debit Spread: This involves buying an option with a higher premium (i.e., a higher strike price) and simultaneously selling an option with a lower premium (i.e., a lower strike price) on the same underlying asset, expiration date, and contract size. This strategy results in a net debit to the trader’s account.
The Bottom Line
Options trading can be complex and involves significant risk, as the value of an options contract is affected by a range of factors including the price of the underlying asset, the time remaining until expiration, and market volatility. It’s important to have a thorough understanding of the underlying asset and the options market before trading options contracts.
