What are Options Contracts?

An options contract is an agreement that gives the buyer of the contract the right, but not the obligation, of purchasing or selling an asset at a specified price (exercise price), over a period of time (Time to Maturity). Notice that since the purchaser of the option has the option to buy or sell, the seller of the option contract has the obligation to deliver or purchase the asset at the specified exercise price.

What Is a Call Option?

A call option gives the buyer the option, but not the obligation, of buying the underlying asset at the exercise price over a period of time (time to maturity). Since the purchaser of the call option has the option to buy, the seller of the call option contract has the obligation to deliver the asset at the specified price. 

Example: Assume you might need to buy €100,000 in 6 months. The current exchange rate is 1.10 US$/€, and you would like to guarantee the exchange rate in case the euros are needed. Let’s assume you could purchase an option at $0.03 per euro to buy the €100,000 in 6 months. If at maturity you need the euros and the exchange rate is above the exercise price, you can exercise the option and complete purchase. If you don’t need the euros at maturity, you can pocket the difference between the market price and the exercise price by either selling the option right before maturity or by exercising the option and immediately selling the euros at the higher exchange rate. If on the other hand, the exchange rate at maturity is below the exercise level of 1.10 US$/€, you would be better off letting the option expire worthless and purchasing the euros in the open market. Notice that in this particular example, the buyer of the call option used the option market to hedge the transaction, protecting him against an unexpected appreciation of the euro vs. the dollar. A different buyer could have executed a similar transaction but with the pure objective of speculating on the potential appreciation of the euro. (For related reading, see: Three Ways to Profit Using Call Options.)

Also notice that the transaction is somewhat different than purchasing a forward or future contract. With a forward or future, the purchaser of the contract would have been obligated to purchase the euros at maturity.  

Below we show the net payout of buying and selling a one-year call option on Microsoft stock.

Payout for one contract (100 shares) of Microsoft June 2018 $75 CALL OPTION @$3.80 Premium

Call buyer has limited downside and unlimited upside, but it is the opposite for the seller: limited upside and unlimited downside.

What Is a Put Option?

A put option gives the buyer the option, but not the obligation, to sell the underlying asset at the exercise price over a period of time. Notice that since the purchaser of the put option has the option to sell, the seller of the put option contract will have the obligation to buy the asset at the specified price.

Example: You can think of buying a put option as buying insurance. When you purchase an insurance policy for your car, you pay a premium (the put price) for the right the sell your damaged or stolen car to the insurance company for its insured amount (the exercise price).  By insuring your car, you limit your potential loss to the amount of the insurance premium. On the other hand, the insurance company can, at best, earn your premium, and, at worst, be obligated to pay you the full insured value for an asset that might be worthless. (For related reading, see: Prices Plunging? Buy a Put!)

The following charts show the net payout for a buyer and seller of a put option contract on Microsoft.

Payout for one contract (100 shares) of Microsoft June 2018 $65 PUT OPTION @$3.76 Premium

Put buyer has limited upside and limited downside, put seller has limited upside (the premium) and a downside only limited by the value of the stock.          

(For more from this author, see: Why Investors Should Use Duration to Compare Bonds.)

 

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