Options Contracts

An options contract is a financial agreement that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (the strike) on or before a set expiration date. Options are used for hedging, income generation, and speculation. They offer leverage and flexibility but carry risks that require careful planning.

Key points

• Two main types: call options (right to buy) and put options (right to sell).
• Buyers pay a premium for the right; sellers (writers) receive the premium but assume an obligation if assigned.
• Standard equity options usually represent 100 shares.
• Option value is driven by the underlying price, strike price, time until expiration, volatility, and interest/dividend expectations.
• American options can be exercised any time before expiration; European options only on expiration.

How options work

Options contract elements:
Underlying asset — stock, ETF, index, currency, interest rate instrument, etc.
Strike price — the agreed price to buy (call) or sell (put).
Expiration date — the deadline for exercising the option.
Premium — the price the buyer pays and the seller receives.

Buyers control upside (for calls) or downside protection (for puts) for a limited, known cost: the premium. Sellers take on obligation and potential risk in exchange for that premium. Because options cost a fraction of buying the underlying outright, they provide leverage: a small premium can control a large notional position.

Calls and puts (roles and examples)

• Call buyer — has the right to buy the underlying at the strike. Profits if the underlying rises above the strike plus premium.
• Put buyer — has the right to sell the underlying at the strike. Profits if the underlying falls below the strike minus premium.
• Option writer (seller) — receives premium and is obligated to deliver or purchase the underlying if the option is exercised. A covered call writer owns the underlying; a naked writer does not.

Assignment occurs if the buyer exercises: the seller must sell (for a call) or buy (for a put) at the strike.

Common strategies (hedging and speculation)

Hedging
Protective put — own the stock and buy a put to limit downside.
Covered call — own the stock and sell a call to generate income, sacrificing some upside.

Speculation and income
Long call or long put — directional bets with limited loss (premium).
Selling options — collect premium; can generate steady income but may expose to large losses (especially naked writing).

Multi-option strategies (combine calls and/or puts)
Spreads (bull/bear) — limit risk and reward by buying and selling related options.
Straddle/strangle — position for large moves in either direction.
* Butterfly, calendar spreads — structures that target specific ranges or time-based moves.

Example (leverage and payoff)

ABC stock at $100:
Buy 100 shares = $10,000 exposure.
Or buy one call option contract (100 shares) with strike $100, premium $2 → cost $200.
If stock rises to $120 at expiration:
Stock owner profit = ($120 − $100) × 100 = $2,000.
Call owner: option value ≈ $20 per share → $2,000 − premium $200 = $1,800 net (9× return on the $200 premium).
If you used $10,000 to buy 50 contracts instead of shares, profits scale proportionally (illustrating leverage). Conversely, if the stock stays below $100, call buyers lose the premium; option buyers can lose 100% of premium.

Risks and benefits

Benefits
Leverage — control more exposure for less capital.
Defined downside for buyers (limited to premium).
Flexibility — use for protection, income, or directional bets.
Strategy variety — nearly unlimited combinations to express market views.

Risks
Time decay — options lose extrinsic value as expiration approaches.
Volatility sensitivity — option prices can swing widely with implied volatility.
Total premium loss — buyers can lose 100% of premium if options expire worthless.
Assignment and margin risk — sellers can face large or unlimited losses and margin calls.
* Complexity and liquidity — multi-leg strategies and illiquid strikes can add execution risk and higher costs.

Pricing factors to watch

• Intrinsic value — difference between underlying price and strike (if in-the-money).
• Time value (extrinsic) — value from remaining time and volatility.
• Implied volatility — expected future volatility embedded in option prices.
• Interest rates and dividends — minor effects but relevant for some strategies.
• Liquidity and bid-ask spreads — impact execution costs.

Practical considerations

• Match expiration to the expected timing of the underlying move.
• Have a plan for exercise, assignment, or closing the position before expiration.
• Consider commissions, tax treatment, and margin requirements.
• Start with basic strategies (protective puts, covered calls) before attempting complex spreads.

Bottom line

Options offer powerful tools for managing risk and pursuing return through leverage, limited-risk positions, or income generation. They require an understanding of option mechanics, pricing drivers, and disciplined strategy execution. Use options intentionally: define goals, manage time horizons, and control position sizes to balance potential rewards and risks.