What Are Options Contracts? #
An options contract is a type of derivative contract that gives the buyer the right, but not the obligation, to buy or sell a specific quantity of an underlying asset at a predetermined price on or before a specified future date.
Unlike futures contracts, where both parties are obligated to fulfill the terms of the agreement, an options contract gives the buyer a choice. The seller (or writer) of the option is obligated to honor the contract if the buyer decides to exercise that right.
Like all derivative instruments, the value of an options contract is derived from the price of an underlying asset.
Why Are They Called “Options” Contracts? #
The term option reflects the fact that the buyer has a choice.
If market conditions are favorable, the buyer may exercise the contract and complete the transaction. If exercising the contract is not beneficial, the buyer can simply allow the option to expire without taking any further action.
In other words, an options contract grants the buyer a right rather than imposing an obligation.
Why Were Options Contracts Created? #
Like many other derivative instruments, options were originally developed as a tool for hedging, or managing financial risk.
For example, an investor who owns shares of a company may be concerned that their value could decline over the coming months. By purchasing an options contract, the investor can reduce the financial impact of a potential price decline.
Similarly, someone planning to purchase an asset in the future can use options to protect against a significant increase in its price.
This ability to manage uncertainty while maintaining flexibility is one of the primary reasons options contracts were created.
How Are Options Used Today? #
Although options were originally designed for risk management, they are now used for many different purposes.
Traders and investors use options to profit from price movements, hedge investment portfolios, generate income by selling options, and construct sophisticated trading strategies for a wide range of market conditions.
As a result, options markets have become one of the most important segments of today’s global financial system.
Which Assets Have Options Contracts? #
Options contracts are available for many different types of underlying assets, including:
- Stocks
- Stock market indices
- Commodities
- Currencies
- Exchange-Traded Funds (ETFs)
- Cryptocurrencies (in certain markets)
In every case, the value of the option depends on the price of its underlying asset.
The Two Main Types of Options #
There are two primary types of options contracts.
A Call Option gives the buyer the right to purchase an asset at a predetermined price.
A Put Option gives the buyer the right to sell an asset at a predetermined price.
In both cases, the buyer is free to decide whether or not to exercise the option. There is no obligation to complete the transaction.
Key Characteristics of Options Contracts #
The defining feature of an options contract is that it grants the buyer a right rather than an obligation.
The seller of the option, however, must fulfill the terms of the contract if the buyer chooses to exercise that right.
To obtain this right, the buyer pays the seller a fee known as the option premium. This premium is the cost of purchasing the option and is generally non-refundable, even if the buyer ultimately decides not to exercise the contract.
Options also provide exceptional flexibility, allowing traders and investors to build a wide variety of strategies for hedging, speculation, income generation, and portfolio management.
Are Options Always Exercised? #
No.
Many options contracts expire without ever being exercised.
If exercising the option would not be profitable at or before expiration, the buyer can simply let the contract expire.
For this reason, unlike futures contracts, a substantial number of options contracts never result in the purchase or sale of the underlying asset.
Summary #
An options contract is a derivative instrument that gives its buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or on a specified expiration date. Although options were originally developed for risk management, they are now widely used for investing, trading, and portfolio management.
One-Sentence #
An options contract is a derivative that gives its buyer the right—but not the obligation—to buy or sell an underlying asset at a predetermined price before or on a specified future date.