What Is an Option Contract?

Options contracts may seem complicated, but they're really not.

What is an options contract? It's simply a financial instrument that investors of all types can use to predict the market's moves or hedge their portfolios.

An options contract gives the holder the right, but not the obligation, to buy or sell a fixed amount of an underlying stock, index, or commodity for a fixed price by a certain date. It is called a derivative instrument because its value depends on the price of its underlying market.

There are two major types of options: calls and puts. Calls give the holder the right to buy the underlying stock or commodity. Puts give the holder the right to sell it.

The options contract itself spells out all of these parameters.

While there are options contracts based on all sorts of markets, including exotic over-the-counter markets, most investors buy and sell options on common stocks. This is very important because options that trade on domestic exchanges are standardized and regulated. That means you can be confident that what you buy is exactly what you think it is.

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In other words, you do not have to worry about who is selling the option or who will have to pay you when you sell the option. And for stock options, you know that each option is based on 100 shares of the underlying stock.

The Parts of an Options Contract

The terms of an options trade are defined in the options contract. Here is a basic option example, although different quote vendors may show different arrangements. Whatever the format, this is all the information needed to define the terms of the options contract.

Apple Nov. 8, 2019 235 call - last price 4.25:

  • Apple Inc. (NASDAQ: AAPL) - the underlying stock for the option.
  • 8, 2019 - the expiration date for the option.
  • 235 - the strike price.
  • Call - defines whether this is a call or a put option.
  • Last price - this is the premium the last purchaser paid for the option. This must be multiplied by 100 to get the dollar cost of the options contract since it controls 100 shares of the underlying stock. Therefore, this option would cost $425 before commissions, if any.

How to Use Options

There are two main reasons for trading options - speculating and hedging.

Many investors speculate using options instead of buying or selling the underlying stock outright. For example, if you are bullish on a stock, you can buy a call option on that stock for a fraction of the cost of the shares themselves. If the stock moves higher, the percentage returns on your options can be many times what you'd get for owning the shares. Gains of 100% and 200% are not uncommon.

Of course, there is no free lunch, and you can lose your investment if the underlying stock does not move higher before the option expires. But the dollar amount you can lose is limited to the smaller premium you paid to buy the option.

For hedging, perhaps you think the overall stock market is about to hit a short-term bump in the road. But you do not want to sell a favorite stock you own for the long term. You can buy a put option on that stock, which will gain in value if your stock falls in price. In this way, it acts as a short-term insurance policy for you.

There are many more ways to use options. You can even combine them to create customized strategies to help you make more money. Make it as simple or complex as you want.

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