An option contract is one of the more complex and perhaps confusing financial terms out there. This is especially true if you are new to the investing field. If you’re a bit confused by the term option contract, don’t worry we’ll make things clear for you.
First, take a deep breath. There is no shame in not knowing what a term is in the financial market. Even financial experts sometimes find themselves hunting down definitions! Now, let’s look at the term. It’s only two words, and you’re already going to be familiar with both of them. Options and contract. Nothing complex about either of those words, right?
An option means you have a choice. A contract means you’ve got an agreement. An options contract basically means you have purchased a contract for an agreed upon price that gives you the option to do something. If you’re still confused, don’t worry, we’re going to keep working away at this until it all makes sense.
Using an example to illustrate options
An options contract gives you the option to buy something at a certain price. Let’s sake Acme Company shares are currently selling for $50 dollars, but you are very confident that prices will rise substantially in the future. Perhaps, you have determined that one of their up-coming products is going to do a lot better than expected. Most people, however, are rather pessimistic.
In this case, you could buy an options contract to buy shares at say $55 dollars. This price will be called the “strike” price, meaning you will be able to buy shares at this price at any time before the options contact expires. If the contract expires six months from now, you’ll be able to buy the stocks at $55 dollars at any point over the next six months. Each contract will allow you to buy one share. In this case, let’s assume you buy 100 of them.
So let’s say that your insights prove to be correct. Stock prices in Acme rise to $75 dollars a share over the next five months. You exercise your option, and buy 100 shares at $55 dollars, netting you a profit of $20 dollars per share, which is good for $2,000 dollars in profits.
You might be wonder why people simply don’t buy stocks, and skip the complications of options. Let’s go back to the example. Remember how you only invested $1,000 dollars. Let’s assume that’s all you could afford to invest. Even if you bought 20 stocks at $50 dollars a share, that increase on your investment would amount to only $400 dollars. Percent wise, that’s a great gain, but you won’t be buying your dream home with it.
Remember how the options only cost $10 dollars? (This is a hypothetical number, by the way, you need to get actual quotes to learn more.) With your thousand dollar investment, you could buy 100 options. You’d then make $20 dollars per option, minus the costs, so you’d net a total of $1,000 dollars. You’re still not going to be able to buy your dream hope, but by buying options you would have more than doubled your profit.
Risk isn’t optional with options
There are risks with options. Remember how we mentioned the expiration date? Before an option expires, it is an active option contract before it expires. After the contract expires, it is no longer active and you can’t exercise the contract. In other words, you either use your option before it expires, or you will lose all of the money you have spent on them.
Stocks, on the other hand, will always be valuable, unless a company goes bankrupt, which is rare. If you buy a commodity, such as gold, you will always have the commodity itself. Even if prices for the commodity drop, at least you have something. With options, this simply isn’t the case.
Interestingly, a lot of major investors, such as head fund managers, will use options as a sort of insurance. If a hedge fund manager has a major stake in a company that they don’t want to sell (maybe because they have someone on the board, for example, or are trying to arrange a merger), they can buy options as a form of insurance in case stock prices drop. If stock prices drop, they can exercise their options to recoup or at least mitigate losses.
Options are used in other fields too, so don’t get the terms mixed. For example, an option 40 contract is a program for army soldiers. Option contracts also refer to contracts in the real estate market. On and on the list goes.
Hopefully, this article will have helped you understand what is an option contract. These are rather complex financial instruments, but once you start working with them, everything will make sense. Of course, you should continue to study up before investing your hard earned money in options. As we have already pointed out, options are a higher risk type of investment. Don’t go gambling your money until you actually know what you are doing! That being said, every investor can invest in options.