What are options contracts?

Options contracts are a type of derivative financial security that gives traders the option, but not the obligation, to buy or sell an asset at a predetermined price. They can be used to hedge against potential losses and to take advantage of price movements, and they can be applied to a wide range of underlying assets, including stocks, bonds, commodities, and cryptocurrencies.

In this AAG Academy guide, we’ll explain what options contracts are in more detail, including how they work. We’ll also look at how they’re used in trading, and the biggest advantages and disadvantages of using options contracts. We’ll also answer some common questions.

How do options contracts work?

Options contracts are essentially an agreement between two parties that gives one of the parties the option to buy or sell an underlying asset at an agreed price on or before an agreed expiry date. The reason why they’re called options contracts is that the agreement is optional — there is no obligation for the contract to be acted up, even if a certain target is reached.

For example, let’s say you’re interested in buying Bitcoin, but you feel its current market value of $22,000 is too high. Instead of waiting for its price to fall, you take out an options contract in which you agree to buy 1 BTC at a price of $18,000 within 30 days. If, within that time frame, the price of BTC falls to $18,000, you then have the option (but not the obligation) to acquire 1 BTC.

This is a rather simple example, but explain how options contracts work in more detail, and explain some of their advantages, later in this guide. Options contracts have become incredibly popular among both experienced and amateur traders since they were first standardized in the early 1970s. Today, they can be applied to a wide variety of assets or financial instruments.

What types of options contracts are there?

To better understand how options contracts work, let’s first look at the two primary options that can be considered:

Call option
A call option gives the contract holder the right to buy a certain asset at a fixed price on or before the contract’s expiration date. As we outlined in the example above, you might have a call option in which you agree to buy Bitcoin at a price of $18,000.

Put option
A put option gives the contract holder the right to sell a certain asset at a fixed price on or before the contract’s expiration date. The easiest way to imagine this is to simply reverse the example above and say that you might have a put option to sell Bitcoin at a price of $22,000.

Although both of these options have expiration dates, unlike perpetual futures contracts, neither of them come with an obligation. Even if you agree to sell Bitcoin at a price of $22,000, you are not forced to do so if the asset’s market value hits that price. If you change your mind after taking out the contract, you can simply not act on it and allow it to expire.

In addition to the two types of options contracts, there are some common terms traders should be aware of before using them for the first time. These are:

• Intrinsic value: The intrinsic value of an option is the difference between its strike price and underlying market price. It can be calculated by simply subtracting the strike price from the underlying market price for a call option, or by subtracting the underlying market price from the strike price for a put option.

• Maturity date: This is the last date on which you can act on an options contract.

• Premium: This is the price paid when opening up an options contract. It varies depending on the strike price, intrinsic value, and maturity date of the contract.

• In- or out-of-the-money: These terms are used to describe whether the option is above or below its strike price. A call option with a price of $100, for example, is in-the-money (ITM) when its underlying asset’s price hits $100 or more. When it is below that price, it is out-of-the-money. These are reversed for a put option.

You might be interested in: What are perpetual futures contracts?

How are options contracts used in trading?

Once a call or put contract has been acquired, there are a number of ways it can be used in trading. If you have a call option and the price of the underlying asset rises, you might choose to acquire the asset and then sell it at a profit, or sell the contract itself at a profit. If you have a put option and the price of the underlying asset falls, the same approaches can be taken.

Continuing with the example from above, let’s say you have a call option to buy Bitcoin at a price of $18,000. Its current price is $17,000, but within 30 days, it rises to $20,000. You could then acquire 2 BTC for $36,000 and immediately sell it for $40,000, earning a $4,000 profit. Or you could sell the contract itself for a $4,000 profit.

Acquiring the asset is a good option in this scenario if you feel its market value will continue to rise, since your profit could be even greater later. However, if you feel its market value will remain steady or fall and you are ready to finish the trade, selling the contract itself is simpler. Different options are available for those with put contracts.

Let’s say, for example, that you sell a put contract for Bitcoin at a price of $23,000. Its current price is $18,000 and the contract expires in 30 days. If the asset’s price does not rise to $23,000 and the contract is not acted upon, you can simply keep your BTC and sell another put contract at a premium. However, if the price does rise to or above $23,000, the buyer can claim the asset at that price and your profit then depends on what you originally acquired the BTC for.

Advantages and disadvantages of options contracts

Although options contracts can be effectively utilized by both experienced and inexperienced traders, it is important to understand both their advantages and disadvantages before using them. Their biggest benefit is the most obvious one: Options contracts give traders the opportunity to take advantage of potential movements in an asset’s price.

What’s more, there’s no need to invest a large sum of money upfront. Although you’ll need to pay a premium to buy an options contract, this is usually considerably more affordable than physically acquiring an asset itself. And because options contracts do not come with an obligation to buy or sell, traders are not forced into moves that they may regret later.

One of the most popular ways to use options contracts — and another big advantage of them — is to hedge against losses on other investments. If you own Ethereum, for instance, and you’re worried its value will drop significantly, you can use options contracts to profit from that price drop and make up some of the money you may lose on the asset itself.

One of the biggest disadvantages of options contracts is that they have expiration dates and can expire quickly if the underlying asset does not move in the expected direction. This can push traders into making decisions that they wouldn’t normally make in an ideal situation simply because they have been rushed — although they aren’t obligated to do so.

Another downside is that options contracts, although more affordable than buying assets outright, can still be expensive. Premiums can vary quite significantly, but if the underlying asset is expensive, the premium is likely to be high, too. This can lead to substantial losses if you buy contracts and things don’t go your way, or you allow them to expire.

References

• Options contract
• Options basics tutorial
• What is an options contract