Options contract| What is an Options contract?

Options contract

Options contract is simply an agreement between two parties for the sale or purchase of some underlying asset. Most people use options contracts for the sale or purchase of stock in a particular company or some asset.

But you can actually use an options contract in many different areas and markets. You can use them in real estate, in business deals, to buy cars. You can use them all over the place. It’s not limited to just the stock market.

But in our case, we’re going to focus on the stock market. Before we dig deeper into it I want to lay the foundation here, I want to give you the overarching theme of what an options contract is and then we’ll dig deeper.

What is an Options contract?

An options contract like I said is just an agreement between two people. In this case, we have our stock certificate which is going to act as the middle. This is what people are agreeing on. This is what they’re building up this contract for.

We’ve got a buyer and a seller, so we have somebody who wants to buy the stock certificate or the stock and we’ve got somebody who wants to sell the stock.

In this case, we’re going to say that, the stock right now is valued at let’s say $10, so this stock (whatever it is) is currently valued at $10. In a typical stock transaction, (just to show you the difference real quick) if the seller owns the stock and the stock is valued at $10, then the stock buyer can come in and buy that stock for $10 and that $10 gets transferred over to the seller and the stock to the buyer.

Simple transaction, the buyer buys it for $10, the seller sells it for $10. In an options type of environment, we have a lot of different scenarios that can happen around that $10 security.

In our case, we use a very simple example just to prove a point. But let's say that option buyer is communicating with that option seller and says that they actually want to buy the stock if the stock goes up in value and they want to buy the stock at some predetermined price in the future.

Let's say they want to buy the stock for $50 a share in the future. This is starting the basis of what this option contract is built around. It is the assumption on one party’s end or another of future value of the underlying stock.

This buyer could go out there and they could buy the stock right now for $10, but what they want to do instead is they want to make an agreement, an options contract between themselves and the seller that says “At some point in the future, I’d actually look to buy the stock for $50.”

First, most people would ask and they’d say, “Why would somebody want to buy the stock for $50?” Well, what if in the future, that stock is actually worth not $50 or not $10, but is actually worth $100 at some point in the future? What if they get a big government contract or they discovered the cure to cancer, whatever the case is?

Now, the stock goes up from $10 to $100. The option buyer had a contract in with the seller to buy the stock at $50 and now it’s worth $100. That’s the reasoning behind why somebody would want to do this in the future on the option buyer side.

Now, just to take a step back for a second, if let’s say the option buyer said that they wanted to buy that stock for $50 in the future, they also have to set a timeline and have to pay consideration to the option seller.

This are two key points that we want to go over now, is that they have to set a timeline, so when is the future date expired, when is expiration of this agreement between two parties.

Let’s say that this agreement only last for one year. From one year from today's date, the option buyer can purchase this stock at any point in the next year for $50 or not. They have the option. That's where the option part of it comes in.

Again, one year from today's date, the option buyer can choose to purchase stock in this company for $50 a share or not. They don't have to, but they can choose to do that. That gives us our timeline of how long this contract last.

After a year is up, let’s say it’s one year and one day from today, then the option buyer no longer has the right to buy that stock at $50. Their contract with the seller has expired. That’s where our expiration process comes into play.

In most options markets, expiration processes can be a week-long to a month, two months, three months, a year, two years, three years, so there’s varying degrees of timeline.

In order for the seller to agree to doing this the seller needs some sort of consideration at present moment. Because again, put yourselves in the shoes of the seller. Now they’re going to say, “Okay, I'm basically guaranteeing that the most I can sell this stock for in the future is $50 and then if it goes anything higher than $50, I’m going to have to sell it to this option buyer for $50. I need some sort of consideration right now to basically give up my right to sell the stock over $50.”

The option buyer can buy it at $50 and sell it for higher price than $50 in the future, it was $100 in the example that we used. Because of this advantage which the buyer enjoys, the option buyer has to pay the option seller some sort of consideration and let's say that in order to execute this agreement, the option buyer pays the option seller let’s say $40.

The option buyer is going to pay the option seller $40 right now. That's the premium that they paid and that basically tells the option seller, “Look, I'm a legitimate buyer, I want to compensate you right now for this contract or this agreement that we’re making and if I don't make good on my contract, meaning if I never buy the stock any time between now and a year later, if I never buy the stock, you get to keep this entire $40 premium for yourself.”

How does an option contract work?

I hope you are with me till now. Great. This is now where things start to get a little bit more confusing, but if you start thinking about it logically, this is why each side of the agreement between the options buyer and seller has a little bit of skin in the game.

The options buyer wants to pay a little bit of money, so they’ll only going to pay $40 right now, but they basically control this stock and hope that it goes above $50 a share or on the other side, the option seller hopes that the stock goes up, but not more than $50 a share because if it doesn't go more than $50 a share, they get to keep this $40 premium for themselves for basically releasing the right to anything above that price.

Hopefully this example makes a lot of sense. It's just an agreement between two people. There’s a million different ways that this can happen. The agreement can be enter at a price of $50 (strike price) or the agreement could be at $40.

There’s a lot of different variations between where the agreements can happen between the two parties. If the current stock price is $10, they might agree to a $40 strike price, meaning that if the stock goes up to $40 or more, then the option buyer will execute their agreement and assign or request the stock from the option seller and they will hope to sell it for more than $40 a share in the market.

There’s a lot of different variations. There can be different time variations. Instead of one year, they might agree to just six months. Instead of doing a one-year contract, they might say, “Hey look, this contract is only valid for six months instead of a year.”

The option consideration or the premium that the option buyer pays to the seller, instead of being $40 amount might only be $30 because it's a lower time or some other different factor. There’s a lot of different ways that it can go, but hopefully this makes a lot of sense about just the basics.

It's just an agreement to buy or sell stock at some point in the future and we’ll get into a lot more of the rights and responsibilities here later on in the track.

Till this point my aim was to simplify the basic concept of options contract. I hope you have a clear idea of it now.

Let’s now understand the different terminologies associated with an Options contract. We will understand this with the help of our above example.

What are the characteristics of an Option contract? 

Below are the different terms we encounter when dealing with options contract 

• Strike price 
• Premium compensation 
• Time consideration 
• Exercise and assignment 
• Rights and obligations

Strike price:

Strike price is the point at which they make an agreement on the future value of the stock. In this case, when we're looking at this example, the stock was worth right now $10. The strike price that they determined for the future value was $50. That is the strike price.

The way that I always explain it is that’s the price at which they strike a deal on the future value of where that stock is and that could be higher or lower than where the stock is now.

Premium compensation:

This is the amount of money transferred from the buyer to the seller for entering that agreement. 

In the options world, the buyer always pays the premium and the seller always receives the premium because the buyer is accessing a right and the seller is giving up an obligation or giving up their right and basically taking on obligations. They have to be compensated for doing that.

In our example above, the initial premium that was paid from the buyer to the seller for this contract was $40. That was how much the buyer was going to pay the seller to enter into this agreement.

Time consideration:

This is a big one. All options contracts have an expiration date. There has to be a time at which they say that this agreement between two parties no longer last. In the options world, that varies anywhere between a week, maybe a month, two months and can be up to many, many years.

There has to be some time component into that contract. As you’ll learn later on, the longer that time component is, the more valuable that contract is because there’s more time for the security to move into a favorable zone.

Exercise and assignment:

This is a big one because most people really don't understand how that works. But let’s go back to our example here to describe how it works.

If let’s say in the future the strike price that we’re going after or the option buyer’s going after is $50 a share and let’s say that in the future, the stock is actually worth $100 a share, not $10, so the value of the stock has gone up from $10 to $100.

In this case, the buyer would request, so they would submit a request to the seller for the stock. That is called an exercise. They’re basically exercising their agreement that they had initially signed, their options contract that they had initially signed and now they are physically requesting the seller to sell them stock at $50, so that they can go out and resell the stock.

Because they’re going to buy it at $50, they’re going to resell the stock for $100 and take in the difference as a profit. That is called the exercise request.

On the seller’s end, what it looks like is it actually looks like the option is being assigned, meaning that the contract that they initially sent over is now being assigned to the option buyer, meaning that they have to give up their stock that they have and now transfer that stock over to the option buyer for the strike price of $50.

That’s the difference between exercise and assignment. It’s actually the same transfer happening. It’s just if you're an option buyer, you exercise your right to buy the stock. If you're an option seller, you get assigned a contract and have to give up that underlying stock.

Hopefully this makes sense.

Rights and obligations:

Rights and obligations are a little bit confusing initially on the outside because you don't really know what’s happening. 

But if you break it down and really think through the process, remember that if you enter into an agreement with the option buyer and you're an option seller, you’ve basically given up your right to the stock for anything above $50.

If the stock is worth less than $50, the option buyer is not going to exercise their agreement. They’re not going to buy a stock at $50 a share when it's only worth $40 a share in the open market. They’d rather go out and buy options in the open market for $40 a share versus buying it from you at $50.

But as the option seller, you don't have that decision anymore. The option buyer has paid you money to basically make the decision on whether they will buy or not buy the actual stock based on the options contract.

The right to buy or not comes with the option buyer. They pay for a right. They pay for the choice to buy or sell that stock or not buy or sell that stock in the future.

As the seller, you have given up your right and now you have an obligation because you took in money, you accepted this contract, you took in that premium from the option buyer, now you have given up your right and now you have an obligation that if they do want to buy (because you agreed on it) that you will sell them stock at a predetermined price in the future.

That’s the difference between rights and obligations and we’ll dive a little bit deeper into this in some other discussion, but for the time being I think hopefully this lays the foundation for what we’re doing here so far with options contracts.

Wrap up

Now, to quickly wrap up everything that we just discussed about, it’s important to understand that an options contract is just an agreement between two parties for the sale or purchase of an asset.

Hopefully this quick visual that we went through lays the foundation for how you can start to understand and develop a trading strategy around options trading versus just going out and buying the stock from the open market.

It gives you a lot of choices, no pun intended, it gives you a lot of options on things you can do, and that creates opportunity for us as traders.