What Is an Options Contract?

Image source: Getty Images.

An options contract is a type of derivative investment that gives you the right but not the obligation to make a trade in an underlying investment. Options contracts have specified expiration dates, and you can choose whether to exercise your option on or before that date or simply allow the option to expire unexercised. Your options contract will also specify the price, known as the strike price, at which you can buy or sell the underlying investment. Many investors never consider options contracts, believing that they are too risky. However, you can also use an options contract to reduce your overall portfolio risk and to provide insurance for certain unforeseen circumstances.

What a typical stock options contract looks like

Options contracts are publicly traded on exchanges, and they tend to have standardized characteristics that depend on the type of underlying investment. For stock options, an options contract typically involves 100 shares of the underlying stock, and expiration dates are available for different months, usually expiring on the third Friday of the given month.

The most important aspect of an options contract is that it's optional. The owner of the options contract has the right to force the seller of the options contract to take the action specified under the contract, but the owner doesn't have to do so. For instance, with a put option, the option owner has the right to sell underlying stock to the person who sold the option, and if exercised, the person who sold the option has no choice but must buy the stock from the option owner. Similarly, with a call option, the option owner has the right to buy underlying stock from the person who sold the option, who must sell stock to the option owner if the option is exercised.

Why people use options contracts

Options contracts are useful for a couple of reasons. First, the seller of the option receives payment, known as a premium, and that belongs to the option seller no matter what happens in the future. Many options traders use received premiums as a substantial source of portfolio income.

Also, the buyer of the option can lock in the right to acquire a stock or other investment at a later date by putting up a relatively small amount of money upfront. Options contracts typically cost just a fraction of what the underlying stock would cost, with the strike price due only if the option owner chooses to exercise the contract. Some investors use cheaper options as a way to increase leverage, but there's no requirement to do so.

Options contracts give investors flexibility in taking action with their investment portfolios. Used well, an options contract can help you control risk and maximize your potential returns.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us atknowledgecenter@fool.com. Thanks -- and Fool on!

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

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright 1995 - 2016 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.