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What is option contract?
Options contract is the contract between parties in which, a buyer has the right to sell or buy a particular asset at future date on agreed price. These types of contract are used in securities, commodities etc.
In this, buyer will look at ask price and if he wants to buy into option contract, he will offer the bid price (which is lower than bid price). After the contract is purchased from the seller, a position is opened and seller is paid to buy an asset on strike price. Buyer has to sell, buy or exercise the contract before an expiry of contract, and, if not the contract is no longer valid. Put and call are types of option contract.
Types
Call option − Buyer gets right but not obligation to buy underlying asset at strike price specified in option contract
Put option − Buyer gets right but not obligation to sell underlying asset at strike price specified in option contract
Features
The features of option contract are stated below −
- Standardized contracts.
- Settled through a cleaning house.
- Premiums are available.
- Over the counter (OTC) can be used.
Advantages
The advantages of option contract are as follows −
- Insurance is provided.
- Capital requirement is low.
- Risk to reward ratio.
Disadvantages
The disadvantages of option contract are as follows −
- Time decay.
- Initial investment is required.
- Huge loss (if movement of price is not as expected).
Example
An investor expects company ABC stock price may go up to $100 within a month. Investor can buy option contract at $3.25 with a strike price of $86 per share.
Number of share = 100 (assume)
Investors need to pay = $3.25 * 100 => $325
By executing call option investor buy 100 shares (prior to expiry date on option contract) at strike price ($86)
Investors need to pay = $86 *100 => $8600
Now the investors want to sell his 100 shares for $12000, profits he gains is
Gain = 12000 – 8600 – 325 => $3075
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