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An options trader at his desk

An option contract is a form of financial asset known as a “derivative.” Purchasing an option contract it gives you the right to buy or sell some underlying asset on specific terms. You choose a price and date on which to trade this asset. When the time comes, you can choose to execute the contract if it’s profitable, or let it expire if not. Here’s what you need to know about option contracts.

What Are Options?

While traders can base an option contract on virtually any tradable asset, the most common come in two forms:

In an option contract you have the right to either buy or sell an underlying asset at a specific price and date. At the expiration date your profits, if any, come from the difference between the asset’s current market price and the price listed in your contract. This is why option contracts are called derivatives, because they derive their value from an underlying asset.

The value of the contract comes, in large part, from the fact that you can choose to make this transaction only if it’s profitable at the expiration date. For example, say you have an option contract to buy 1,000 ounces of coffee on Jan. 1 for $1.10 per ounce. On Jan. 1, when this contract expires, you can either choose to exercise it or not, depending on whether it’s profitable.

There are two types of options contracts: call and put.

  • Call Options – This contract gives you the right to buy an underlying asset at a specific price and date. Call options are profitable if the asset price rises. For example, in the example above where you have a call option for coffee at $1.10 per ounce on Jan. 1, the option will be profitable if coffee costs $1.20 on Jan. 1, because your contract lets you buy coffee for $0.10 less than it’s worth on Jan. 1.
  • Put Options – This contract gives you the right to sell an underlying asset at a specific price and date. Put options profit if the asset’s price declines. For example, say you have a put option for coffee at $1.10 on Jan. 1. If the price of coffee declines to $0.90 on Jan. 1, your contract will give you the right to sell it for $0.20 more than it’s worth on Jan. 1.

A contract that expires in a profitable position is called “in the money.” Unprofitable contracts are “out of the money.”

You can buy – or “write” – an option contract for virtually any tradable asset, but most are written for either commodities or stocks. In a commodities contract, the option addresses goods traded on mercantile exchanges. These are physical goods and raw materials such as lumber, iron, coffee and gold.

A stock contract, more commonly known as a stock option, gives you the right to buy or sell shares of stock. These are very common as a perk of employment for corporate officers. Companies will often give executives stock options as part of their compensation, in which they have the option to buy the company’s stock for a given (typically low) price after a number of years of employment.

How An Option Contract Works

Every option contract has four specific components:

  • Asset – The underlying asset being traded and in what quantity.
  • Expiration Date – The date on which the contract expires.
  • Strike Price – The price at which you trade the contract’s underlying asset on the expiration date.
  • Contract – The position of the option contract, whether a put or a call.

So, in our sample contract, we would have the following elements:

  • Asset – 1,000 ounces of coffee
  • Expiration Date – Jan. 1
  • Strike Price – $1.10
  • Contract – A put contract

This sample contract would give you the right to buy 1,000 ounces of coffee on Jan. 1 for $1.10 per ounce. Say that on January 1 the price of coffee has gone up to $1.20 per ounce, a difference of $0.10. You would make $100 (1,000 ounces times $0.10).

Options can resolve in two different ways.

  • Physical Settlement – Under this contract, you have the right to actually buy or sell the underlying asset. For example, in our sample contract involving coffee beans, a physical settlement contract would have you actually buying 1,000 ounces of coffee beans at the time of the contract’s expiration. This is uncommon with commodities, but very common with stock options.
  • Cash resolution – In a cash resolution, traders don’t actually exchange the underlying assets. Instead, when a contract expires, traders exchange the cash value of the underlying assets. So, in our sample involving coffee beans, if you exercised your option at the contract’s expiration date you would receive a payment based on the difference between the contract’s price and current price of coffee.

Profits and Premiums

The price of an option contract is called its “premium.” Traders set an option’s premium based on how likely they think it is that the contract will expire in the money, and based on how many units of the underlying asset the contract represents.

For example, our coffee contract might have a premium of $0.05 per ounce. This means that you would have to pay $50 ($0.05 times 1,000) to buy the contract.

Ultimately, options are a bet between two traders about how prices will move. When someone sells a call option, it’s because they think that the price of this asset will stay below the contract’s strike price. When they sell a put option, they believe that the asset’s price will stay above it. In either case, they set their premium based on how likely they think this is. The higher the premium, the more likely they think it is that the contract will expire in the money.

Long shot contracts, on the other hand, tend to sell quite cheaply.

As a trader, your profits are based on the difference between how much the contract cost and how much you made off it. Say you entered the contract to buy coffee for $1.10 on January 1, with a premium of $0.05 per ounce. If coffee costs $1.30 on the expiration date you’d profit $0.15 per ounce (the $0.20 difference between contract and market, minus the premium cost of $0.05).

Premiums are an up-front cost. If you don’t exercise your contract at all, they are simply lost. However, that’s also the extent of your losses. You can’t lose more on an option contract than it cost up front.

The Bottom Line

Options are a financial product that give you the right to buy or sell an underlying asset at a specific price, on a specific date. They’re built around giving you the option to pass if the contract expires in an unprofitable position. If you would make money, you can exercise your contract. If you would lose money, you can simply walk away.

Tips for Investing

  • Consider talking to a financial advisor about whether options are a good way to mitigate risk in your portfolio. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Options are based on a form of product called a futures contract. Learn more about where options came from and how futures work in SmartAsset’s explainer on the subject.

Photo credit: ©iStock.com/Traimak_Ivan, ©iStock.com/PashaIgnatov, ©iStock.com/chaofann

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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