Options Contract
An options contract gives its buyer the right, but not the obligation, to buy (a call) or sell (a put) an asset at a set strike price on or before an expiry date. The buyer pays a premium; the seller, or writer, takes on the obligation.
Also called: option · options · call option · put option
Every option has an underlying, a strike price, an expiry date and a premium. The buyer of a call profits if the underlying rises above the strike; the buyer of a put profits if it falls below. If the market moves the wrong way, the buyer simply lets the option lapse. Options that can be exercised at any time up to expiry are called American; those exercisable only at expiry are called European, whatever market they trade in.
The payoff is asymmetric. The buyer's maximum loss is the premium paid, while the writer collects the premium in return for an obligation whose cost can be far larger, so writers usually have to post margin. The premium reflects the distance between the strike and the current price, the time to expiry, interest rates and, above all, how volatile the underlying is expected to be.
For payments and treasury work, the option's value is flexibility. A forward locks a rate and obliges the holder to deal, which is a problem when the underlying flow is uncertain, such as a tender priced in a foreign currency that may not be won. An option caps the cost of the bad outcome while keeping the benefit of a good one, at the price of the premium. That makes it a hedging tool for uncertain exposures and, bought without an exposure, a leveraged bet like any other derivative.
In practice
The premium is spent whatever happens, and options far from the current price often expire worthless. Structures sold as zero-cost usually contain an option the client has sold, which brings back an obligation.
Example
A US company buys an option to buy €1 million at 1.10 dollars in three months for a premium of US$15,000. If the euro is at 1.15 at expiry, it exercises and saves US$50,000 against the market, US$35,000 after the premium. If the euro is at 1.05, it lets the option lapse, buys at the market and has lost only the premium.
Learn more on Money Wiki
This page gives the short answer. Money Wiki has a longer guide to Options Contract, with more detail and background.
Commonly confused with
| Term | How it differs |
|---|---|
| Futures contract | Both sides of a futures contract are obliged to perform. Only the writer of an option is obliged; the buyer has a right it may choose not to use. |
See also
- DerivativeA derivative is a contract whose value comes from the price, rate or event it references, called the underlying. It lets parties take on or shed exposure to that underlying without buying or selling the underlying itself.
- Forward ContractA forward contract is an agreement to exchange one currency for another on a future date at a rate fixed today. It creates a binding obligation on both sides — which is what makes it useful for certainty and dangerous if the underlying payment never happens.
- Futures ContractA futures contract is a standardised, exchange-traded agreement to buy or sell an asset at a price fixed today, for delivery or cash settlement on a set future date. A clearing house stands between the two sides and collects margin.
- HedgingHedging is taking a position that gains when an existing exposure loses, so that a move in a price, rate or currency leaves the combined result roughly unchanged. A hedge reduces uncertainty; it does not guarantee a profit or rule out a loss.
- Spot RateThe spot rate is the price for exchanging one currency for another for near-immediate settlement. "Immediate" is a convention rather than a fact: standard spot settlement in most currency pairs is two business days after the trade.