What Is an Options Contract?

By Markets Fool.com

You can invest successfully throughout your entire lifetime without ever having to do anything with the options markets. Yet those who do buy and sell options can take advantage of investing strategies that aren't available to those who simply trade stocks, mutual funds, and exchange-traded funds. By better understanding what an options contract is, you can find ways to integrate options into your overall strategic plan and potentially reduce your risk while increasing your potential return. Below, we'll take a closer look at what options contracts are and why they might be useful to you.

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What an options contract is

An options contract is an agreement between a buyer and a seller that gives the buyer the option to trade an underlying asset at a specified price within a certain period of time. The option buyer has the right but not the obligation to force the option seller to follow the terms of the agreement at any time before the option expires. The price for the underlying asset specified in the option is known as the strike price and is different from the price that the buyer actually pays for the options contract. Typically, options contracts on stocks cover 100 shares, although some special contracts have different amounts of stock.

The key aspect that all options contracts have in common is that the option buyer has all of the control over the contract. The option buyer can exercise the option and force the option seller to follow the agreement's terms. However, the option buyer also has the right simply to allow the option to expire without exercising it. In that case, nothing further happens, and the option seller simply keeps the amount that the buyer paid for the option with no further obligation.

2 types of options contracts

There are two main types of options contracts, and although they're similar in many ways, they have different terms. A call option gives the buyer of the option the right to buy the underlying asset from the option seller at the specified strike price. For example, a December $80 call on a stock would give the option buyer the right to buy the stock at any time between now and December for $80 per share.

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A put option, on the other hand, gives the option buyer the right to sell the underlying assets to the option seller at the strike price. This can get confusing, because the buyer of the option is the seller of the stock and vice versa. However, the idea works roughly the same way. For instance, a December $80 put option would give the buyer the right to sell the stock to the option seller for $80 per share at any time before the December expiration.

When options are profitable

One aspect of options contracts that many investors find disturbing is that you can lose the entire amount you pay for them. For a call option, if the price of the underlying asset remains below the strike price of the option, then it will never make sense for you to exercise the option contract. As a result, your best move will be to allow it to expire worthless, and if you still want to buy the stock, you can do so more cheaply on the open market.

For a put option, the reverse is true. If the price of the underlying asset remains above the strike price, then you won't want to exercise the put and sell your stock at a lower price than the market. Instead, letting the option expire is the better choice, and you can sell your stock at the higher market price if you want.

Even though you can lose your entire investment with an options contract, the amount you'll pay to buy one is typically far less than what you'd spend buying the underlying asset. Some options traders use that attribute to make leveraged bets that can produce big payoffs but also involve substantial risk. But there's no requirement that you use options that way, and those who use them in conjunction with existing portfolio positions can reduce the risk of their overall portfolio by hedging against certain potentially adverse outcomes.

Options can seem complicated, and many people see them as being risky. Used correctly, though, options contracts can help you control and manage your investing risk, and that makes them extremely valuable for those looking to fine-tune their exposure to the financial markets.

The article What Is an Options Contract? originally appeared on Fool.com.

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