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What is an Options Contract?

Alexis W.
Alexis W.

An options contract is a financial term that is used which allows an individual to buy an asset — usually shares of stock — at a set or given price. In other words, such a contract allows an individual to maintain a possible interest in shares of a company, or an interest in another asset, without actually owning the asset. Options contracts provide an investor with the opportunity to leverage his funds, but can be a risky investment.

An options contract gives the purchaser the right, but not the obligation, to buy given shares of a stock at a set price. For example, a share of stock A may be selling at $10.00 US Dollars (USD) currently. A person could buy an options contract to buy shares of that stock for $11.00 USD. This means that if the stock goes above $11.00 USD, the individual who owns the options contract could still purchase the shares at $11.00 USD.

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Businessman giving a thumbs-up

The price at which the individual has the right to buy is called the "strike" price. In the above example, the $11.00 USD option would have a strike price of $11.00 USD. If the price of the stock went above $11.00 USD, the owner of the option would be "in the money."

People can either buy or sell options contracts. A person who sells the contract sells "puts." A person who buys the contract buys "options."

Options contracts are always sold on the stock market in terms of 100 shares. This means that to sell such a contract, or to sell "puts," an investor would need to own 100 shares of the stock. In addition, this means that the person who buys the contract would be buying the right to purchase 100 shares of stock at the given price.

Individuals can buy and sell contracts without ever actually exercising the option or owning the stock. For example, if a person owned the option to buy stock at $11.00 USD and the stock was at $12.00 USD, the person could buy 100 shares of the stock at $11.00 USD and then sell the stock for $12.00 USD. Alternatively, the individual could avoid buying the stock at all and simply sell the $11.00 USD call to another investor.

Options contracts have a set expiration date. If the contract expires and the stock does not go above the strike price, the individual loses his original investment, or the money he paid to acquire the option contract. As a result, investing in an options contract is considered a risky investment and an investor must apply for permission to engage in such trading through a brokerage firm.

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