What is an option contract?
How does it work?
What are some examples of option agreements in real-life?
We will look at what is an option contract, how it works, option agreement definition, what are the contract features, option contract on stock, bond and real estate, types of options contracts, their validity under contract law and nuance with the Uniform Commercial Code (UCC), examples and more!
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Table of Contents
What is an option contract
An option contract (also referred to as options) is a contractual agreement between two parties who agree on a future transaction’s essential terms and conditions.
In other words, in options contracts, the parties will agree on:
- The underlying asset (the property or asset the parties may transact in the future)
- The transaction price (also known as the strike price)
- The option contract term (the period during which the options can be exercised)
- Premium (or option price representing the price the option buyer pays the seller to acquire the option)
Option contracts are often used to transact on securities (stocks, publicly traded securities, employee stock purchase plans), commodities (raw or primary material) or real estate (property or land).
If you have a call option and the spot price (the fair market value of the underlying asset) is higher than the strike price, you can earn a profit.
If you have a put option and the spot price is below the strike price, you can earn a profit.
On the flip side, if the spot price is lower than the strike price in a call option or higher in a put option, the option buyer loses the premium paid for the option and the option will expire.
We will discuss call and put options in this article so be sure to keep reading
In many cases, option agreements are considered risky and speculative.
They are essentially a leveraged bet on future price volatility of stocks, securities or assets.
Options can also be purchased to hedge against market risk.
The parties transact today in speculation of future market conditions.
The option price or premium to pay is typically significantly lower than the market value of the underlying asset.
As a result, savvy investors can use options as a form of leverage to take advantage of stock price volatility without having to pay for the full value of the underlying stock.
When an option buyer speculates on the underlying asset’s price to go up, he or she can purchase call options.
When the option buyer speculates on the price of the underlying asset to go down in the future, he or she can buy put options.
How does an option contract work
The option buyer purchases the right to exercise the “option” or demand the seller to perform certain obligations at any time before the options expire.
What’s important is that the buyer does not have an obligation to demand the performance of the obligation from the seller.
However, the seller has a legal obligation to perform his or her promise in case the buyer requests it.
The option seller earns some money today (option price) but will have an obligation to transact with the option buyer if the buyer chooses.
In essence, an option contract is a form of buy and sell contract where one party promises to buy or sell an underlying asset for a certain period of time.
The seller of the option bargains away his or her right to revoke the offer or promise thereby giving the other party the option to demand the execution of the promise.
For example:
John owns a real estate property worth $300,000 today.
John enters into an option contract with Mary where she is granted the right to purchase the property (underlying asset) at $350,000 (strike price) at any time during the next year (option term).
Mary pays John $10,000 as a consideration (option price) to enter into the options contract.
As a result, Mary now has the option (no obligation) to buy John’s property at any time during the next one-year period for $350,000.
Let’s assume that ten months later, the price of the property goes up to $400,000.
Mary can exercise her option and purchase the property at $350,000 although it has a market value of $400,000.
On the flip side, if the property does not appreciate in value or remains below $350,000, it will not be advantageous for Mary to exercise her options.
The options will expire and John will have earned $10,000 as profit.
Option contract definition
According to Cornell Law School’s Legal Information Institute, an option contract is defined as:
A promise to keep an offer open that is paid for. With an option contact, the offeror is not permitted to revoke the offer because with the payment, he is bargaining away his right to revoke the offer.
This option contract legal definition provides key legal concepts that we can extract:
Options contract features
In most cases, buyers and sellers transact options listed on derivative markets or options markets.
In this context, the options contracts (call option contract or put option contract) are standardized allowing investors to make better and informed investment decisions.
For example:
Stock option contracts are standardized where each option contract gives the option owner to buy or sell 100 units of shares.
In options markets, you can purchase:
- Stock options
- Commodity options
- Bond options
- Index options
- Futures options
If you enter into a private options contract with someone, you are entering into an over-the-counter option contract.
In other words, the option contract is not standard and you privately define the terms and conditions applicable to your options.
Over-the-counter options can relate to:
- Real estate property
- Land
- Interest rate options
- Currency exchange rate options
- Swaps
- A specific asset or security
The most common form of options (and the one average investors may have heard of) is stock options.
Generally, an option contract has the following features:
- Premium
- Strike price
- Expiration date
- Underlying asset
- Optionholder rights
The premium is how much an option buyer agrees to pay the seller when buying option contracts.
The strike price is the price the option seller or writer promises to purchase or sell an asset in the future and on-demand.
The expiration date is when the option contract expires and the buyer loses the right to demand the execution of the seller’s promise.
The underlying asset is what the buyer and seller are transacting upon (it can be an option contract for real estate, stocks, bonds, commodities or other).
The optionholder rights is the right given to the buyer to purchase (“call option”) or sell (“put options”) the underlying asset from or to the seller.
Types of options contracts
There are typically two types of options contract:
- Call options
- Put options
These types of options allow the optionholder to exercise the option by forcing the other party to sell an asset (“call”) or purchase an asset (“put”).
These are well-known in the financial services industry.
Entire markets are built for individuals and companies to transact options allowing them to purchase or sell a particular stock at a specific price in the future.
Let’s explain.
Call options
A call option is when the option seller (or the call writer) agrees to sell the underlying asset to the option buyer at a pre-determined price for a certain period of time.
You may have heard of options on stocks or stock indexes.
Perhaps, the options market or derivatives.
In the open market, millions of people speculate on stock prices going up or down by buying options.
When an investor or trader speculates that a particular stock will appreciate in value, they can purchase call options to earn a profit from the price appreciation.
The standard options contract in stock markets allows the option buyer to transact on 100 shares of the underlying stock.
If an investor intends to speculate on 1,000 shares of the underlying stock, he or she will need to purchase 10 options contracts.
For example:
Today the stocks of a technology company are trading at $1,000 per share.
Helen purchases a call option as a leveraged bet on the stock appreciating in the next six months to $1,500 per share.
Helen purchases call options on the options market for $5,000 giving her the right to exercise her options and purchase 100 shares at $1,200 per share.
If the tech company’s shares go up to $1,500 per share, then Mary will have earned a good profit from her options.
Mary will have to exercise her options by paying the strike price to the option seller ($120,000) in order to purchase the shares having a spot price or fair market value of $150,000.
The call options give her an immediate profit of $30,000.
From the $30,000, you must deduct the amount Mary paid to purchase the option contract ($5,000) leaving Mary with a net profit of $25,000.
Put options
Put options work in the same way as call options but in the opposite manner.
Instead of betting on a stock appreciating in price, a buyer of a put option bets that a stock’s price may go down.
If the stock depreciates, the option buyer will earn a profit.
The holder of a put option has the right, but not the obligation, to force the put option seller (put writer) to purchase the underlying asset from the option buyer.
Let’s look at our call option example but assuming that we are dealing with put options.
Today the stocks of a retail company are trading at $1,000 per share.
Helen purchases a put option as a leveraged bet on the stock dropping in value in the next six months to $500 per share.
Helen purchases put options on the options market for $5,000 giving her the right to exercise her options and sell 100 shares at $800 per share.
If the retail stocks drop to $500 per share, then Mary will have earned a good profit from her options.
Mary will have the right to sell 100 shares to the seller for the strike price ($80,000) although the market value of the shares is lower ($50,000).
The put options give her an immediate profit of $30,000.
From the $30,000, you must deduct the amount Mary paid to purchase the put option contract ($5,000) leaving Mary with a net profit of $25,000.
Option contract law
Option contracts are legally binding agreements just like any other contract.
Contract law
In the context of an option contract, you all the legal requirements for a valid contract to be formed:
- Defined parties
- Offer by the promisor
- Acceptance by the promisee
- Legal capacity
- Consideration
The parties are the option buyers (who can be an investor, speculator, trader, hedge fund, portfolio manager) and the option seller (or the writer).
There is offer and acceptance as the option seller promises to buy or sell a defined asset, at a specified price and before a specific date on demand and the option buyer accepts the terms.
The option buyer pays the option seller as his or her consideration to bargain away the right to revoke the offer or promise to buy or sell the underlying stock for a specific period of time.
In the event the buyer demands the performance of the seller’s “offer” or “promise” to buy or sell the underlying asset or security, the writer is legally bound to perform the obligation.
Failure to perform the promise will be considered a breach of contract.
From a legal perspective, an option contract is a type of contract relating to underlying goods or real property where the purchase or sale is conditioned upon the terms defined in the option agreement such as a time factor or a specific action.
Uniform Commercial Code
Under the Uniform Commercial Code or UCC, a firm offer is one where the merchant makes an offer to the buyer and must keep it open for a period not exceeding three months.
An option contract under standard contract law is when a party keeps an offer open for a certain period of time in exchange for consideration whereas a firm offer is when a person making an offer cannot revoke the offer or bid for a certain period of time based on the terms of the offer.
Firm offers between merchants are governed by UCC.
In essence, when UCC applies, the element of “consideration” is removed from the equation when making firm offers between merchants in some circumstances.
In other words, the promisee does not have to pay a premium for the promisor to keep the offer open.
Option contract example
Let’s look at a real-life example to see how options work for both the option buyer and seller.
Let’s say that a bank stock is trading at $50 per share.
A call option seller sells a three-month option for $500 giving the option buyer the right to buy 100 bank stocks at $60 per share.
If the bank stocks remain under $60 per share in the next three months, the option buyer will not exercise the options and the option seller can keep the $100 as profit.
When the options are not exercised, they will expire with the passing of time.
However, if the bank stock goes up to $75 per share, the option buyer has the right to purchase 100 shares of the bank stock at $60 per share.
Once the shares are purchased, the option buyer sells the stock on the market at $75 per share, making a $15 per share profit.
If you take the option buyer’s profit of $1,500 and you deduct the price paid for the option at $500, the option buyer makes a net profit of $1,000.
Option contract FAQ
Define option contract
An option contract is a contractual agreement between two parties who agree on the essential terms and conditions of a future transaction between them.
An option contract can be purchased in a standardized manner on the open market or in the context of a private transaction (over-the-counter option contract).
Typically, in options contracts, the parties will agree on the following option contract elements:
- The underlying security
- The strike price
- Expiration date
- Premium to the seller
- The buyer’s rights
Example of option contract
There are many examples and types of option agreements.
Here are some examples based on the underlying goods or securities:
- Stock option
- Commodity option
- Bond option
- Index option
- Futures option
- Swaps
- Currency option
Also, a contract for option comes in different flavours.
The most common types are:
- Call options (buyer has the right to demand that seller delivers a good, asset, property or security)
- Put options (buyer has the right to demand that seller buys a good, asset, property or security)
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