What is an Option Contract?
An option contract in its most simple terms is an agreement between two parties to buy or sell some underlying asset or stock at a predetermined price in the future.
A call option gives the option trader the right but not the obligation to buy shares of a stock at a predetermined price in the future.
A put option gives the option trader the right but not the obligation to sell shares of a stock at a predetermined price in the future. O
ptions are unique in that they have a predetermined expiration dates and strike prices which causes a little confusion for people who make the transition from stock trading (since you can hold a stock forever).
We'll take a deeper look into understanding options with a simple but effective example using a fast-food coupon.
In today's video tutorial, I want to talk about the absolute barebones basics of what is an option contract. A lot of you who are probably watching this video are very new to options trading, or you’ve never even heard of options trading, so I’m going to break it down in a very easy way for you guys to understand.
And by the end of the day, you’ll know completely what an options trading contract is and be better prepared to move forward with learning more about trading. Why do we have them?
Options were created to manage one thing, and that's risk, and it’s how you use these options to manage the risk that creates the different features, whether you hedge, speculate, use it as insurance, etcetera.
What’s important when trading options are that you clearly define the benefits and risk of each and every position you enter into ahead of time and we talk about this all the time on our options trading blog at optionalpha.com.
This is a constant, constant conversation that we need to have as you get more and more involved in options trading. Remember that risk when trading options are being transferred and accepted each day by different parties. Let’s get into it.
What is option contract? Options are simply a legally binding contract agreement between a buyer and a seller to buy and sell stock at a fixed price over a given period and that's the difference here between options and stocks in general, is that you agree on a fixed price and a fixed period, and then the market can change after that.
There’s two types of options out there, there are calls, and there are puts. Call options give the owner of the option the right, (but here’s the tricky part) not the obligation to buy a stock at a specific price by a certain time. Let’s read it again.
It gives the owner the right, but not the obligation, meaning that if I own a call option, I have the choice, or you would even say “the option” to buy that stock at that price over a certain period, and I don’t have to exercise or execute that agreement or that order.
With put options, it’s a little bit different. This gives the owner of the put the right, but not the obligation to sell stock at a specific price by a certain time.
I can enter a new put agreement and have the choice to sell stock at a certain price if it hits that price or not or goes through it and have the choice to execute or engage that contract with the person that I had bought that from.
Think of coupons. And this is really why it’s not complicated because we use options everywhere that we go today. It’s just how you look at it. Here's a really stupid coupon for RB’s roast beef sandwiches which I happen to love.
RB’s roast beef sandwiches have a sandwich for $3.99. That's the strike price, that $3.99 that we already have in there as far as a price that we’ve determined. RB’s and I have determined through their coupon that they’re going to give me a roast beef combo for $3.99.
When is the date? This is the expiration date; it’s in April. And you can see right down here in the fine print that at the end of April 2009…
This coupon is a little old for when we’re doing this video, but you understand that at the end of April in 2009, we would’ve had to execute this agreement or give them the coupon to buy this roast beef combo at $3.99. In this particular case, this is a call option on the roast beef combo.
If the roast beef combo at the day that I go in there (and it’s before April) is actually $5 on the real live “trading screen” of RB’s, right up there on the menu, it’s $5, then I can actually give them this coupon and buy it at $3.99 and in that case, I’d be exercising my option to buy it at $3.99.
Let’s take the other half. I don’t have to do that, but in that case, it’s beneficial for me to exercise the option. But let’s take the other side of the example and let’s say that I go RB’s that day and whatever RB’s I go into upon the live trading screen on their menu, they have roast beef combos on sale for $2.99.
I wouldn’t give them this coupon because it wouldn’t be any good to me. I’d be buying this roast beef combo at $3.99 when I can just clearly go ahead and buy it right now for $2.99. It does me no good.
In that case, I have this call option on the roast beef combo, but I’m not going to exercise that option because it's not in my best interest.
And you can easily substitute one thing and one thing only and that’s how it relates to trading, is substitute this roast beef combo for any stock that you have out there Apple, Amazon, BIDU, etcetera.
That is the substitute. The strike price, the expiration date and how the logistics of it work is all the same for anything that you would substitute out there.
Again, let’s review. We just really have to hammer this home again. A call option, you buy the stock at a fixed price at a future date, it has an expiration period, it’s like a coupon.
With put options, you sell stock at a fixed price at a future date. We didn’t go over an example like the coupon one that we did for the call option, but hopefully, you guys understand the differences between them, and hopefully that was a real down and dirty, very low understanding of how options contracts work.
It's hard on the outside, but when you get into it, option contracts are very easy to understand. I hope this video tutorial helped you guys with that. Thanks so much for watching this video.
If you have any questions on how contracts work, please let me know via the comment section right below and don’t forget to share this video if you thought it was helpful on any of your favorite social networks.
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