What’s an Options Contract? | Definition, Types & Examples


Options contracts are agreements between the buyer and seller facilitating a transaction for an underlying asset or security at a later date at a prespecified price (strike price).

Option contracts apply to securities, commodities, and real estate transactions and purchase them like other assets within brokerage accounts. The seller or writer of the option remains with no choice but to stay obligated to deliver or buy the underlying asset when the option gets exercised. 

Options Contract in a nutshell

  • Options contracts allow transactions for assets at a predetermined price at a later date.
  • They offer a cost-effective way for investors to speculate or hedge against underlying securities.
  • Buyers pay a premium to purchase call options anticipating an asset price increase, while put options anticipate a decrease.
  • Binary options contracts simplify trading with fixed payouts based on yes/no propositions.

What are Options Contracts used for in investing?

Options contracts are financial tools tied to underlying securities like stocks, commonly utilized by investors for hedging and speculation purposes. They offer a cost-effective alternative to trading the underlying shares directly and are a form of leverage. Options allow investors to bet on the performance of a stock without having to buy or sell the shares directly.

What are the key components of Options Contracts?

Options contracts have specific terms and conditions including details such as the underlying asset, the strike price and the expiry date. Typically, a standard stock contract encompasses 100 shares, although adjustments may be made for factors like stock splits, special dividends, or mergers.

Example: How do Options Contracts work?

Options contracts work by having buyers review the asking price – the amount the seller wants to receive – before agreeing to the terms. The buyer offers to buy the options contract by offering a bid price lower than the asking price. After purchasing the contract from the seller or writer, a position opens. If the buyer agrees to execute the contract, the seller gets paid to sell (buy) the asset at the predetermined price. Buyers also receive the right to buy (sell) an asset at the strike price. However, it does not impose any obligation on the party. 

Let’s take a look at an example. The investor expects the price of ABC Co.’s stocks to increase to $90 within the next month. However, he finds that he can purchase an options contract for the same company at $4.50 with a $75 per share strike rate. He would have to pay $450 ($4.5*100) for the options contracts.

Per the expectations, the stock price began to rise and stabilized at $100. The investor executes the call option before the expiration and purchases all the 100 shares at $75. Since the stock values at $100, you can sell it in the market for the same price and earn a profit of $2050 ($10,000- $7,500-$450 = $2,050). 

What are the different types of Option Contracts?

  • Call options: These contracts are for investors requiring the right to purchase the asset at the strike price. The buyer pays the premium when entering into the contract. Buyers purchase call options (Binary Options) when they feel the security price will increase and sell them when they see a fall.
  • Put options: The buyer sells the asset at an agreed-upon strike rate in put options (Binary Options). There is a risk in premium payment, but the profit potential is high.

What is a Binary Options Contract?

Binary options contracts are a special type of options contract based on a simple yes/no proposition. Traders speculate on whether the price of an asset will go above or below a certain threshold. The simplicity lies in the binary outcome: either the investor earns a fixed payout for a correct prediction, or they lose their entire investment for an incorrect guess.

Trading Options

When placing a trade, traders have two options: Call, which predicts a higher future price, or Put, which predicts a lower future price. The potential payouts can be substantial, ranging from 75% to 95% of the initial investment

Example

Let’s break down binary options contracts with a real-world example using the Pocket Option platform. Suppose we’re interested in trading Gold and decide to invest $1000. We choose a short expiry time of 5 minutes, meaning our prediction needs to happen quickly. PocketOption offers a payout rate of 86% for trading Gold.

In this scenario, we decide to go with a Call option. This means we’re betting that the price of Gold will go up within the next 5 minutes. If our prediction turns out to be correct and Gold’s price rises during this time, we’ll earn a profit of 86% on our initial investment, which is $860. However, if Gold’s price doesn’t go up as we expect, we risk losing the entire $1000 investment.

The volatility of the underlying asset drives options contracts. Investors use this option to protect themselves from adverse price movements. Lower capital requirements and a better probability of risk-reward ratio make it an attractive option.

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About the author

Marc Van Sittert
Marc Van Sittert is an experienced Binary Options Trader and coach who is originally from South Africa. He started his career in 2014 by trading old-school Binary Options online. His main focus is on short-term contracts with 60-second trades.

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