Option Contracts Defined: Understanding the Basics

Option contracts are a financial derivative used to give the holder the right, but not an obligation, to buy or sell an underlying asset at a predetermined price and time. These contracts are commonly used in the stock and commodities markets to hedge against risk or speculate on future price movements. In this article, we will provide an overview of option contracts and their key terms.

Call and Put Options

Option contracts can be categorized as either call or put options. A call option gives the holder the right to buy the underlying asset at a predetermined price, known as the strike price. A put option, on the other hand, gives the holder the right to sell the underlying asset at the strike price. Both call and put options have an expiration date, after which they become worthless.

Premium and Strike Price

The premium is the price that the option buyer pays to the option seller for the right to buy or sell the underlying asset. The premium is calculated based on the current market price of the underlying asset, the strike price, and the time remaining until the expiration date. If the underlying asset`s price moves in the direction that the option holder predicted, the option holder can profit by either exercising the option or selling it to another investor.

The strike price is the price at which the underlying asset can be bought or sold. The strike price is predetermined at the time the option is created and remains fixed until the option expires. The difference between the strike price and the current market price of the underlying asset is known as the option`s intrinsic value.

Call Option Example

Let`s say that an investor believes that stock ABC, currently trading at $50 per share, will rise in value within the next six months. The investor purchases a call option with a strike price of $55 for a premium of $2 per share. If the stock price rises to $60 per share before the option expiration date, the investor can exercise the option and buy the stock for $55 per share, realizing a profit of $3 per share. Alternatively, the investor can sell the call option to another investor for a profit.

Put Option Example

Now let`s consider a put option. An investor is worried that the price of gold, currently trading at $1,500 per ounce, will fall within the next three months. The investor purchases a put option with a strike price of $1,400 for a premium of $50 per ounce. If the price of gold falls to $1,300 per ounce before the option expiration date, the investor can exercise the option and sell the gold for $1,400 per ounce, realizing a profit of $50 per ounce. Alternatively, the investor can sell the put option to another investor for a profit.

Conclusion

Option contracts can be a useful tool for investors looking to hedge against risk or speculate on future price movements in the stock and commodities markets. Understanding the basics of call and put options, the premium, and strike price is essential for anyone interested in using these financial instruments. However, as with any investment, it is important to do your research and consult with a financial advisor before making any decisions.