What is an Option Contract?


Introduction:

An option contract is a agreement that grants the option contract buyer the right to execute a trade in the future, on 100 shares of equity. The contract buyer also has the right to chose not to execute the trade.

You use option contracts to trade shares of equity in the future at a purchase price specified today.

This contract is an agreement from the option-writer (seller) to purchase or sell a security at a specified price, called a Strike Price. The contract buyer loses the right to chose to execute the trade at a specified day, called an expiration day. It can be executed anytime before expiration by the contract buyer only. Additionally, the buyer can chose to not to execute the option contract if it would be unprofitable to do so.

We often use the term Underlying Security, when talking about options. We’re referring to the security being traded by terms of the contract. When trading options, we quickly change between discussing the price of the contract itself and the price of the underlying.

This underlying security is typically a share of equity, such as: stock, index, or ETFs (Exchange Traded Funds).

Options contracts on an Index vs. a stock/ETF are settled differently. If you chose to purchase an index option contract, it is important to understand how these are different.

With stocks/etfs, you settle your option by trading the underlying security. So the exercising the contract means you trade the equities.

With indices, you only exchange money—the value of the index, at the quantity specified. This is because index’s aren’t physically tradable, which means you only exchange the value of that index.


If you are already familiar with option contracts, then ignore this article and read about option strategies.

I have a section dedicated to option strategies or click on of the links here to connect to some of the introductory strategies:

#1: Covered Calls and Protective Puts
#2: Collars
#3: Long and Short Straddles



Essential to understand:

Here is a short list of vocabulary used in this article. If you already know what they mean, just scroll past this.

If you read the term and description and still don’t understand, don’t worry. Just keep reading below because seeing each of them used in context later in the article will help improve your understanding.

Positions:


Call:
The call-contract writer is bound by obligation to sell 100-shares of a security at a specified price before a specified contract expiration date to the call contract buyer. The contract buyer can chose whether or not to exercise this contract.

Put:
The put contract writer is bound by obligation to buy 100-shares of a security at a specified price before a specified contract expiration date from the put contract buyer. The contract buyer can chose whether or not to exercise this contract.

Long:
Buying an option contract, whether a call or a put.

Short:
Writing and then selling an option contract, call or put. (Note: The position you have is only short if you wrote the contract — I.E. you can buy a call and then sell your call contract later if you’d like, and this doesn’t turn it into a short position trade)



ASPECTS OF AN OPTION:


1 Option Contract = 100 Equity Security shares traded,
At the: Strike Price
Before the: Expiration Date

Both, the cost of buying the option contract, and the income received from writing (selling) the option contract are referred to as premiumthe price of the option contract.

Security:
A security is actually a pretty large definition basically encompassing any share of value or indebtedness. We use this term when referring to Equity Securities like stocks, bonds and ETFs, typically.
Though, an Option contract is also a type of security, known as a Derivative.

Underlying Security:
An Option contract is an agreement to trade an equity security. We use the word underlying to specifically differentiate the between the contract and thing traded to due the contract. Specifically, when talking about price.

Expiration Date:
The date that the buyer of the option contract no longer has the right to exercise the contract. On this day the option contract expires worthless to the owner of it.

Strike Price:
Specified by the contract writer, this is the price that the underlying security will be traded for once and if the contract is exercised.

Moneyness:


In The Money (ITM):
This is when the option contract has intrinsic value and extrinsic value. That is, when the current price of the underlying security is able to be acted on for a profit (not factoring for the premium spent purchasing the contract). With calls, this is when the security price is above the strike price. With puts it is when the security price is below the strike price.

At The Money (ATM):
This is when the option contract has zero intrinsic value, but contains extrinsic value. This is when the current price of the underlying security is exactly the same as the strike price. If you exercised a contract that was ATM you would make and lose zero dollars.

Out of The Money (OTM):
This is when the option contract has a negative intrinsic value and only has extrinsic value. That is, the only value of the contract comes from time value until expiration, and changes in implied volatility. Due to these two factors there is a chance that the contract will become profitable. Because it only has the chance of profit, the value of the contract is called extrinsic value.


You can either be a buyer or a writer of option contracts.

CallPut
Option Contract Buyer• Purchases a contract where they have the option to buy 100-shares of a security at a specified price, before a date specified by the writer.

The buyer of the call contract hopes to use this after a considerable price gain in order to buy a security for lower than the current market price, and then sell it for immediate profit.
• Purchases a contract where they have the option to sell 100-shares of a security at a specified price before a date specified by the contract writer.

The buyer of the put contract hopes to use this after a considerable price decrease in order to sell a security for higher than the current market price.
Option Contract Writer• Writes and sells a contract where they agree to sell 100-shares of a security at a specified price, before a specified time, to the contract buyer.

The writer of the call hopes that the price of the security never increases enough for the call to be profitable/exercised by the contract buyer; UNLESS, they write the contract at a strike price that they find profitable, in that case they hope that it does get exercised so they make money on the strike and the premium.

They write and sell this contract in order to gain addition income via premium.
• Writes and sells a contract where they agree to purchase 100-shares of a security from the contract owner at a specified price, before a specified date.

The writer of the put hopes that the price of the security never falls enough for the put to be profitable/exercised by the contract buyer.

They write and sell this contract in order to gain addition income via premium.

Long Calls and Long Puts

Briefly put, as a buyer or a writer, you have two choices: Calls or Puts.

If you’re the buyer of the option contract, it is called going “long. You go long on calls or long on puts.

A long call is a bet that the underlying security will raise in value before the stated expiration day.

A Long put is a bet that the underlying security will decrease in value before the stated expiration day.

Profit and Loss when establishing Long Positions:

Profit Potential when buying (going long on) Call or Put option contracts:

• On a call, the profit is theoretically unlimited.

The price of the underlying security can technically increase forever, thus increasing the difference between the current price (in the future) and the strike price — this difference is where profit is captured.

• On a put, the profit potential is limited to the stock price.

Meaning that, the profit is capped to the difference between: (strike price + the premium) and (XYZ market price approaching $0).

Loss Potential when buying (going long on) Call or Put option contracts:


• On both calls and puts the loss potential is limited to the premium you pay for the option contract.

Though, you can offset this by selling your Long option contract before the expiration date for some amount.

The value you can sell of your long option contract will be priced according to a variety of factors such as: implied volatility (until expiration), days until expiration, and how close it is currently to the strike price.

Potential profit due to changes in implied volatility before the expiration date gives your option contract extrinsic value.

This potential for profit is what gives your option contract the value that it has.



Long Call – Buying a Call Option Contract

Again, a Long Call is betting that the price of an underlying security, is going to increase in price, before a stated expiration day.

When buying the Long Call you chose the price that you agree to buy the (100 shares of) underlying security at, which is called the Strike Price.

The strike price is the price that the option contract writer, AKA contract seller, has agreed to sell the underlying security at. The seller agrees to make this sale before a stated day, called expiration day.

The sale is only executed if the price of the traded security exceeds the average cost per share of the strike price plus the premium spent on the contract. Only then is it is in the option buyer’s best interest to choose to do so–because this is the only time executing the contract is profitable.

This is why it is called an option. The buyer of either a put or a call contract has the option to execute the contract, while the contract seller is obligated by contract to follow through with their agreement.

To buy this contract you pay what is called a premium, typically seen in the form of the price of the option contract per share. This is then multiplied by 100 because a single contract is an agreement for 100 shares.

When would you buy a long call option contract?

You would establish a long call position when you think that the price of a security might increase.

The goal is that the market price increases so much that it exceeds the strike price.

You then buy the security from the contract writer at the strike and profit by selling it at the higher market price.

When calculating the profit you can make from an option, you have to consider the Strike Price, plus the Premium you paid for the contract.

You wont execute a contract solely at the Strike Price, because you would lose money by exactly the value of the Premium. So any profits you plan to make will be calculated as such:

[ (Predicted Market Value of the underlying security*100 shares) – ( (strike price*100 shares)+Premium paid) ] >= $0.00



If the underlying’s price never makes it to a profit point, you don’t have to execute the contract (AKA not buy the 100 shares) and all you lose and risked is the price you paid in Premium to buy the Contract.

Long Put – Buying a Put Option Contract

Opposite to a long call, a Long Put is purchasing a contract in which the buyer has the right (buy not the obligation) to execute a sale of 100 shares of the underlying security to the contract writer, at a specified price and time.

When would you buy a long put option contract?

The contract buyer purchases this agreement hoping that the market price of the underlying security will fall below the strike price of the contract.

When this happens they can sell the security for a price that is higher than the current market price.

Once it does, the contract buyer will purchase the underlying security at what ever current price the security is at, and then sell it to the contract writer for a higher price, the strike price.

This will make more sense accompanied with the following scenario:

Example (Long Put)

  • XYZ is trading at $100 per share, today.
  • You conduct analysis that leads you to believe XYZ will fall to $80 per share within the next month.
  • You purchase a put contract with a $90 strike price and you pay a premium of $300 (or a $3 premium per share) for the put contract agreement.
  • This means that if XYZ falls below $87 per share, you will buy XYZ and sell it to the contract writer.
  • XYZ falls to $77 per share, and you chose to exercise the contract. To do this you do the following:
  • You buy 100-shares of XYZ for $77 and sell those shares to the contract writer for the strike price written in your put option contract, $90.
  • You receive $1000 from this trade, however when you account for the premium to paid for the contract agreement, the $300, you net $700 from XYZ falling in price and taking advantage of this by having purchased a put option contract agreement.




Writing Short Call and Short Put Contracts

When you write an option contract, it is called establishing a Short option contract. You are short only if you write the contract, when someone buys it, the contract is a long position for the buyer.

When writing the option contract you chose the strike price, the expiration date and the premium for the contract. (However, the market value for the premium you charge is based off of the current rate for similar contracts based on the theoretical options pricing models mentioned in “The Greeks” article [link auto-opens in new tab] )

Profit and Loss when establishing Short positions:

Profit Potential when writing and selling (going short on) Call or Put option contracts:

• The profit potential for both short calls and short puts is limited to the premium that you collect (for taking on the risk potential of the buyer actually executing the contract).

The pro to going short is that, for example in a short put position, if XYZ goes up in price you win, if XYZ price stays the same you win, and if XYZ price falls below the strike price but not enough to compensate for the premium the buyer paid, you still win.

You win on 3 out of 4 situations.

Loss Potential when writing and selling (going short on) Call or Put option contracts:

In theory the loss potential is unlimited.

• With calls; lets say that you sell a call on XYZ, in theory, XYZ price can gain an unlimited amount of value above the strike price you designated, and you potentially sell XYZ for an unlimited amount of loss.

• With puts, the loss potential is limited to the stock going to $0.

Where you end up buying a stock that has a market price of $0.0001 and the strike price of $90 which you designated weeks ago when you sold the contract.

When writing contracts it is extremely important to do enough analysis where you write successful strike prices that lead to a worthless contract for the buyer.

Short Call – Writing and selling a Call Option Contract

This is when you write and sell a contract to a buyer which states that you will sell 100 shares of XYZ stock at a specified price and before a specific expiration day – or not at all if the buyer chooses.

When would you write a short call option contract?

You would write a short call if you believe that company XYZ is going to fall in price or, at least that the price won’t go higher than the strike price (+ premium charged, divided by 100). If it doesn’t, this option will be un-excerciseable to the contract buyer

Example (Short Call)

If XYZ stock price is currently $100.0 a share and you think that it’s not going to go higher than $110.0 at anytime before expiration(an expiration that you chose), you’ll sell an option with a share premium of $ 0.80 or $80.0 for the contract.

Then somebody comes along and buys your contract because, for some reason, their analysis led them to the idea that XYZ will in-fact be worth more than the $110.0 strike price and worth more than the $110.80 break even price, hoping that they can execute it for a profit.

Luckily you’re better at analysis than this shmuck, or your strategy involved hedging, so you’re pretty sure that the premium, that the buyer paid you in exchange for you risking to sell XYZ shares below a market price in the future, is pure profit for yourself.

So you collect a quick $80.00 premium, and move on with your day. Probably, by investing that $80 into new equity shares in hopes for more profit.



Short Put – Writing and selling a Put Option Contract

This is when you write and sell a put contract, and in this, you are agreeing that you will buy 100 shares from the put contract purchaser at a specified price before a specified expiration date.

When would you write a short put option contract?

You write this contract hoping it never gets executed and that the option expires worthless for the contract buyer.

Example (Short Put)

You write this contract if you see stock XYZ selling at $100 per share.

Due to your analysis, you believe that XYZ is going up in price and it is unlikely to fall or, at least, unlikely to fall by much in the near future. So you write and sell a Put contract. Which states that you’ll buy 100 shares of XYZ from someone at $90 before some expiration date. Since it is pretty unlikely it’ll fall much, the market price per share of this option contract is cheap. Only costing $1.20 or $120.0 for the full contract premium price.

You collect the premium immediately as compensation for the risk. The premium you are paid makes it worth the risk.

You’re successful on your Short Put option contract position if XYZ never falls below the break even price. Nothing else happens, you’ve already collected premium, the contract expires worthless to the buyer and you go on with your time making other trades.



“Moneyness”

If the underlying security’s price is below the Strike Price, the contract is called being “Out of the Money” (OTM).

When the underlying’s price is equal to the strike price it is called “At The Money” (ATM).

If the underlying’s price is more than the strike price it is called being “In The Money” (ITM). FYI, you can be In The Money and be unprofitable. Until the current price per share of the underlying security is more than:

( share strike price + (the premium paid divided by 100 shares))

These terms: OTM, ATM, ITM, are terms for Option Moneyness.

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About the author: Dominick Muniz
Creator, web-developer, and writer at The Trading Space.

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