We will introduce the concept of options contracts and how they are used in the stock market. In our introductory discussion, we will be focusing on the most basic way to get involved in options, which involves buying options contracts based on bets you make on whether future stock prices will rise or fall.
What is an Options Contract?
Contents
An options contract sounds fancy but it’s a pretty simple concept.
- It’s a contract. That means it’s a legal agreement between a buyer and a seller.
- It allows the purchaser of the contract to purchase or dispose of an asset with a fixed amount.
- The purchase is optional – so the buyer of the contract does not have to buy or sell the asset.
- The contract has an expiration date, so the purchaser – if they choose to exercise their right – must make the trade on or before the expiration date.
- The purchaser of the contract pays a non-refundable fee for the contract.
While the focus of this guide is on options contracts related to the stock market, some options contracts take place in all aspects of daily life including real estate and speculation. A simple example illustrates the concept of an options contract.
Suppose you are itching to buy a BMW and you’ve decided the model you want must be silver. You drop by a local dealer and it turns out they don’t have a silver model in stock. The dealer claims he can get you one by the end of the month. You say you’ll take the car if the dealer can get it by the last day of the month and he’ll sell it to you for $67,500. He agrees and requires you to put a $3,000 deposit on the car.
If the last day of the month arrives and the dealer hasn’t produced the car, then you’re freed from the contract and get your money back. In the event he does produce the car at any date before the end of the month, you have the option to buy it or not. If you wanted the car you can buy it, but of course, you can’t be forced to buy the car, and maybe you’ve changed your mind in the interim.
The right is there but not the obligation to purchase, in short, no pressure if you decided not to push through with the purchase of the car. If you decide to let the opportunity pass, however, since the dealer met his end of the bargain and produced the car, you lose the $3,000 deposit.
In this case, the dealer, who plays the role of the writer of the contract, has the obligation to follow through with the sale based upon the agreed upon price.
Suppose that when the car arrives at the dealership, BMW announces it will no longer make silver cars. As a result, prices of new silver BMWs that were the last ones to roll off the assembly line, skyrocket. Other dealers are selling their silver BMWs for $100,000. However, since this dealer entered into an options contract with you, he must sell the car to you for the pre-agreed price of $67,500. You decide to get the car and drive away smiling, knowing that you saved $32,500 and that you could sell it at a profit if you wanted to.
The situation here is capturing the essence of options contracts, even if you’ve never thought of haggling with a car dealer in those terms.
An option is in a sense a kind of bet. In the example of the car, the bet is that the dealer can produce the exact car you want within the specified period and at the agreed upon price. The dealer is betting too. He bets that the pre-agreed to price is a good one for him. Of course, if BMW stops making silver cars, then he’s made the wrong bet.
It can work the other way too. Let’s say that instead of BMW deciding not to make silver cars anymore when your car is being driven onto the lot, another car crashes into it. Now your silver BMW has a small dent on the rear bumper with some scratches. As a result, the car has immediately declined in value. But if you want the car, since you’ve agreed to the options contract, you must pay $67,500, even though with the dent it’s only really worth $55,000. You can walk away and lose your $3,000 or pay what is now a premium price on a damaged car.
Another example that is commonly used to explain options contracts is the purchase of a home to be built by a developer under the agreement that certain conditions are met. The buyer will be required to put a non-refundable down payment or deposit on the home. Let’s say that the developer agrees to build them the home for $300,000 provided that a new school is built within 5 miles of the development within one year. So, the contract expires within a year. At any time during the year, the buyer has the option to go forward with the construction of the home for $300,000 if the school is built. The developer has agreed to the price no matter what. So if the housing market in general and the construction of the school, in particular, drive up demand for housing in the area, and the developer is selling new homes that are now priced at $500,000, he has to sell this home for $300,000 because that was the price agreed to when the contract was signed. The home buyer got what they wanted, being within 5 miles of the new school with the home price fixed at $300,000. The developer was assured of the sale but missed out on the unknown, which was the skyrocketing price that occurred as a result of increased demand. On the other hand, if the school isn’t built and the buyers don’t exercise their option to buy the house before the contract expires at one year, the developer can pocket the $20,000 cash.
What is an options contract on the stock market?
On the stock market, we are betting on the future price itself, and the shares of stock will be bought or sold at a profit if things work out. The critical point is the buyer of the options contract is not hoping to acquire the shares and hold them for a long period like a traditional investor. Instead, you’re hoping to make a bet on the price of the stock, secure that price, and then be able to trade the shares on that price no matter what happens on the actual markets. We will illustrate this with an example.
CALL Options
A call is a type of option contract that provides the option to purchase an asset at the agreed upon amount at the designated time or deadline. The reason you would do this is if you felt that the price of a given stock would increase in price over the specified time. Let’s illustrate with an example.
Suppose that Acme Communications makes cutting edge smartphones. The rumors are that they will announce a new smartphone in the next three weeks that is going to take the market by storm, with customers lined out the door to make preorders.
The current price that Acme Communications is trading at is $44.25 a share. The current pricing of an asset is termed as the spot price. Put another way, the spot price is the actual amount that you would be paying for the shares as you would buy it from the stock market right now.
Nobody knows if the stock price will go up when the announcement is made, or if the announcement will even be made. But you’ve done your research and are reasonably confident these events will take place. You also have to estimate how much the shares will go up and based on your research you think it’s going to shoot up to $65 a share by the end of the month.
You enter into an options contract for 100 shares at $1 per share. You pay this fee to the brokerage that is writing the options contract. In total, for 100 shares you pay $100.
The price that is paid for an options contract is $100. This price is called the premium.
You don’t get the premium back. It’s a fee that you pay no matter what. If you make a profit, then it’s all good. But if your bet is wrong, then you’ll lose the premium. For the buyer of an options contract, the premium is their risk.
You’ll want to set a price that you think is going to be lower than the level to which the price per share will rise. The price that you agree to is called the strike price. For this contract, you set your strike price at $50.
Remember, exercising your right to buy the shares is optional. You’ll only buy the shares if the price goes high enough that you’ll make a profit on the trade. If the shares never go above $50, say they reach $48, you are not obligated to buy them. And why would you? As part of the contract deal, you’d be required to buy them at $50.
We’ll say that the contract is entered on the 1st of August, and the deadline is the third Friday in August. If the price goes higher than your strike price during that time, you can exercise your option.
Let’s say that as the deadline approaches, things go basically as you planned. Acme Communications announces its new phone, and the stock starts climbing. The stock price on the actual market (the spot price) goes up to $60.
Now the seller is required to sell you the shares at $50 a share. You buy the shares, and then you can immediately dispose of these at a quality or optimal amount, or $60 a share. You make a profit of $10 a share, not taking into account any commissions or fees.
The Call Seller
The call seller who enters into the options contract with the buyer is obligated to sell the shares to the buyer of the options contract at the strike price. If the contract sets the strike price at $50 a share for 100 shares, the seller must sell the stock at that price even if the market price goes up to any higher price, such as $70 a share. The call seller keeps the premium. So, if the buyer doesn’t exercise their option, the call seller still gets the money from the premium.
Derivative Contracts
You probably heard about derivatives or derivative contracts during the 2008 financial crisis. While they can be designed in complex ways, the concept of a derivative contract is pretty simple. What this means is that the contract is based on some underlying asset. For an options contract, the asset is the stock that you agree to buy or sell. The contracts themselves can and are bought and sold. That is why you may have heard about people trading in derivatives.
So, if you buy an options contract using the Apple stock price as a basis, the term “underlying” would apply to the stock from Apple.
Profits from the Call
Keep in mind the brokerage may have some additional fees. However, using our numbers remember that we paid a premium of $1 per share, and the strike price was $50. Computing for profit is one of the basics when it comes to trading. It is where profits are determined and forecasted for future options to buy or sell.