Posted on 20 June 2012.
What are option contracts? The term is used quite frequently in trading circles, but novice investors are often left wondering as to the specific meaning of the phrase. This somewhat confusing phrase belies a relatively simple practice, though it is necessary to understand the theory behind the practice to understand the meaning of the phrase. Fortunately, this practice is one of the few in the financial world that can be easily explained in simple English. In short, an options contract is the right to buy a specified amount of stock at a specified time for a specified price.
That may be the simple answer to the question of what are option contracts, but the full explanation requires a bit more depth. An options contract is an agreement between two parties – a buyer (holder) and a seller (writer). The holder and the writer make an agreement that a certain amount of stock (usually one hundred shares) will be available for the purchase of a party designated by the holder for a certain price at a certain time. The holder pays a certain price as consideration for this option, which may or may not be exercised before the option expires. If the option is exercised, the writer is required to sell the stock to the indicated party at the agreed upon price no matter the current value of the stock.
As you might imagine, option contracts are often used as a protection measure. This sort of trading is a good way to make sure that one can acquire stock at a particular price regardless of short-term fluctuation, allowing a holder to minimize his or her risk by simply paying the option premium. As such, understanding these contracts requires not only understanding how they work, but also the motivations of the parties to the contract. One might say that the answer to what are option contracts requires knowing as much about the nature of the business world as it does stock knowledge.
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