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An option contract is a financial derivative that gives the buyer the right (but not the obligation) to buy or sell an underlying asset at a predetermined price within a specified time period. Options are widely used for hedging, speculation, and income generation.
What is an Option Contract?
An option contract allows investors to lock in the right to transact an asset at a specific price (the strike price). The buyer pays a premium for this right, while the seller (or writer) assumes the obligation to fulfill the contract if exercised.
Definition
An option contract is a legally binding agreement that grants the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined strike price before or at expiration.
Key Takeaways
- Options give rights to buyers and obligations to sellers.
- Call options give the right to buy; put options give the right to sell.
- Buyers pay a premium; sellers receive it in exchange for risk.
- Options are used to hedge risk, speculate on price movements, or generate income.
Understanding Option Contracts
Options are flexible instruments traded on exchanges or over-the-counter (OTC). They derive their value from underlying assets such as stocks, commodities, indices, or currencies.
Key terms include:
- Strike Price: The price at which the option holder can buy or sell the asset.
- Expiration Date: The last day the option can be exercised.
- Premium: The cost paid by the buyer to obtain the option.
- Intrinsic Value: The immediate exercise value.
- Time Value: Additional value reflecting future potential.
The two main types of options:
- Call Options: Right to buy an asset.
- Put Options: Right to sell an asset.
Options can be American-style (exercisable anytime before expiration) or European-style (exercisable only at expiration).
Real-World Example
An investor buys a call option on a stock with a strike price of $100. If the stock rises to $130 before expiration, the investor can buy at $100 and sell at market price, generating profit. If the stock stays below $100, the investor can let the option expire, losing only the premium.
Importance in Business or Economics
Option contracts are essential because they:
- Provide hedging tools to reduce financial risk.
- Enable speculative trading strategies with limited risk.
- Offer leverage—small investments can control large positions.
- Support liquidity and stability in financial markets.
Corporations use options to manage currency risk, commodity price volatility, and equity compensation plans.
Types or Variations
Call Option: Right to buy an asset.
Put Option: Right to sell an asset.
American Options: Can be exercised anytime before expiration.
European Options: Can be exercised only at expiration.
Exotic Options: Complex variations such as barrier options, Asian options, and binary options.
Employee Stock Options: Compensation contracts offering future share purchase rights.
Related Terms
- Derivatives
- Futures Contract
- Premium
- Strike Price
- Put-Call Parity
- Hedging Strategy
Sources and Further Reading
- Chicago Board Options Exchange (CBOE)
- U.S. Securities and Exchange Commission – Options Guide
- CFA Institute – Derivatives and Risk Management
Frequently Asked Questions (FAQs)
Do option buyers have to exercise their option?
No. They can let it expire if it is unprofitable.
Who receives the option premium?
The seller (writer) of the option receives the premium upfront.
Are options risky?
For buyers, the risk is limited to the premium paid. Sellers face potentially unlimited losses depending on the position.
