What is an option contract and how do they work?

When you’re trading in stocks and shares, you know that prices may fluctuate before you’re ready to make the deal.

But there’s a way to ensure a current price for a future purchase — by utilizing an option contract.

So, what is an option contract, and how does it work? 

What exactly is an option contract?

An option contract is an agreement used to facilitate a possible transaction between two parties.

It governs the right to buy or sell an underlying asset or security, such as a stock, at a specific price.

This is called the strike price, and it’s fixed until the contract’s expiration date.

The contract defines the essential terms and conditions, including details of the underlying security, the strike price, and the expiration date.

It’s possible to buy options contracts to speculate on stocks or to sell them to generate income. 

Apart from stock options, there are commodity options, bond and interest rate options, and index options.

Traders use options for hedging, but they’re also found in the financial industry and real estate transactions.

How do options contracts work?

Now that we know the definition of an option contract, how exactly does it work? First, one party makes an offer and agrees that the offer will be open for a specified period of time.

The other party may provide valid “consideration”, such as a deposit to keep the offer open.

The parties agree on the expiration date and the specified price at which the buyer can purchase the asset by that date.

The buyer of the option pays a premium, which the seller (or option writer) receives, no matter what happens with the contract after that point.

Once the contract is purchased, the buyer can buy (sell) an asset at the strike price—but they’re not obligated to do so.

The seller must sell (buy) an asset at the agreed strike price if the buyer chooses to execute the contract.

You can purchase standardized option contracts from an exchange or create a private transaction.

For the latter, you’ll need the best contract management software to ensure you’ve included all the essential elements.

What are the types of option contracts?

Here are the two main types of option contract explained.

1. Call option

Call option contracts are designed for investors or buyers who want the right to buy shares or other assets at the strike price.

As a buyer, you purchase a contract and pay an option premium up front to the seller (also called the writer), who assumes the obligation to sell their shares at the strike price.

When the stock price rises, the call option increases in value. So, as long as the stock market moves in the buyer’s favor, they’ll make a profit. 

2. Put option

Put option contracts are basically the opposite, in that a buyer would typically purchase one when they expect the stock price to fall (at which point the put option increases in value).

The buyer owns the right to sell their shares at the strike price stated in the put option agreement.

If the spot price is lower than the strike price prior to or at expiration, they can either assign shares to the option seller for purchase at the strike price (which the seller is obligated to do) or sell the contract if the shares aren’t held in the portfolio.

The buyer is then considered to be “in the money.”

Options contract examples

Here are some examples of how options contracts can work in practice. 

Startup companies and small businesses may offer option contracts as part of their benefits package, where employees have the option of purchasing shares in the company at a low price.

In real estate, a lease option contract allows someone to rent a residential property and purchase it when the lease expires. They also have the option of renewing the lease. The owner is typically prohibited from selling the property during the lease term.

How many contracts are in an option?

In most cases, stock option contracts include 100shares of the underlying stock, but it’s possible to adjust them for special dividends, mergers, or stock splits.

You’re allowed to buy multiple contracts if you wish. For instance, if you bought three call options contracts, you’d have the right to buy 300 shares.

How much does an option contract cost?

There are several prices involved in option contracts. The strike price is the agreed-upon price at which the underlying security may be bought or sold by the option holder. The spot price is the current market value of the underlying asset.

The premium (paid by the buyer to own the contract) is the option’s market price. It’s not the market price of the underlying stock.

This price can also change over time and is based on its intrinsic value, its time value, and the volatility of the asset. The price of the option also depends on prevailing interest rates and demand for the option.

What happens when your option contract expires?

Every option contract has a fixed expiration date, providing you with a timeframe during which you have the option of buying, selling, or exercising the contract. 

When the contract reaches the expiration date, it’s no longer valid.

Its value is settled among options traders, and the option expires—either with a definite value or no value. That’s one of the risks of options trading.

Personalize your option contracts using PandaDoc

Option contracts can offer high returns over a short period. But there’s also the risk of losing money.

That’s why you need a legally binding contract where both parties know exactly what they’re signing up for and what the risks are.

Whether it’s a call or put option, contract management software or a document workflow solution like PandaDoc can help you create, manage, and sign professional contracts that clearly state the terms of the transaction and protect everyone’s interests.