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What is an options contract?

Options mean alternatives or flexibility. In financial terms an options contract is another type of financial derivative. Similar to a futures contract, an options contract can be used for the purposes of both hedging and speculating. However there are also some important differences.

As the investor in a futures contract, you have to take a position (long or short) that is opposite to your initial position in the futures market, in order to close the futures contract before or on the expiration date. With an options contract, you do not have to do anything on or by the expiration date if you don’t need to. Hence an options contract offers more flexibility to the investor.

An options contract gives you the right but not the obligation to buy or to sell the underlying asset at the agreed price before or on the expiration date. If it gives you the right to buy, then it is known as a call option; if it gives you the right to sell something in the future, it is called a put option.

The options market

Similar to a futures contract, there is a market for options contracts. Generally speaking, if you buy stocks, you will want to sell them sometime in the future, so you need to buy at a lower price and sell at a higher price in order to make a profit. Unfortunately you can’t know what the market price will be when the time comes to sell the stocks. To protect yourself from any possible losses caused by unfavourable changes in prices, you can buy a put option, which gives you the right to sell stocks at a price you are happy with before or on the expiration date. Because an option contract doesn’t impose any obligations, you have in fact bought an insurance for your stocks. If, say, in three months’ time, the stock market price is indeed lower than you are willing to sell for, then you can exercise the option – you call the person who sold you the put option, requesting to sell him your stocks at the price written on the options contract. By doing so you make a profit and the person who sold you the option makes a loss.

On the other hand, if the market price of stocks in three months’ time is higher than you expected, then the put option you bought has no value any more. In this case, you can just throw this piece of paper (the put option) in the bin and sell your shares directly to the market. It’s a win-win situation for both you and the person who sold you the put option, as you don’t have to sell your shares to him. Therefore, an options contract offers some protection against any market situation that’s not in your favour.

Because of the flexibility an options contract provides, you need to pay the seller of the options contract when you buy it. In other words, an options contract has a price on it at the beginning of the transaction. It’s known as the options premium, and is similar to an insurance premium on an insurance policy.

Apart from call options versus put options, there is also a distinction between the types of options you can buy, namely European options and American options. In the former, it’s only possible to exercise the option on the expiration date, whereas in the latter, the right can be exercised at any time up to the expiration date.

Over to you

Suppose you are a speculator and you have bought a European-style call option on a stock (you have bought the right to buy the stock at an agreed price on the expiration date). In what circumstances would you exercise the option, and when would you leave the option unexercised?

Use the comments to discuss the question and share your answers with your fellow learners.

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This article is from the free online course:

Risk Management in the Global Economy

SOAS University of London