Understanding Stock Options Contracts

By Ronald Kimmons. May 7th 2016

Stock is the unit that corporations use to divide up the ownership of the company in such a way that multiple owners can easily buy and sell it. Due to this ease of trade, stocks traded on public markets frequently fluctuate in price. A stock options contract is an agreement made between two parties regarding the purchase or sale of a particular stock in the future. Someone who has stock options can make a profit by exploiting the difference between the buying or selling terms in the contract and the current market value of the stock. Read on to find out more about stock options contracts.

Specifications Of The Contract

A stock options contract must specify a number of things. These common specifications include the following:

  • Call Or Put: Since stock options contracts can be for either the buying or the selling of stock, this designation must be part of each contract. A “call” contract outlines the option to buy a stock while a “put” contract outlines the option to sell it.
  • Quantity: Another essential aspect of a stock options contract is the matter of quantity. It must stipulate how many shares may be bought or sold.
  • Strike Price: A stock options contract also must state a specific price at which the stock will be bought or sold. This is the “strike price”.
  • Expiration Date: A stock options contract almost always comes with time limitations. For this reason, the call or put option can only be exercised up to a specific point. This is the expiration date. After the expiration date, if the contracted options have not been exercised, they are no longer applicable.
  • Settlement Terms: The parties involved in an options contract may settle it in various ways. For instance, the contract may result in the transfer of the actual stock or in the transfer of cash based on the value of the stock.

Stock Options For Employees And Strategic Partners

One of the most common uses for stock options contracts is for paying corporate employees. In addition to their normal wages, employees may enjoy the right to purchase company stock at some future point at a discounted price. If the company does well, its stock values will go up beyond the strike price, and employees can purchase the stock at a discount. Such emolument methods are beneficial to employers because they incentivize and encourage high performance among employees. Stock options contracts can also be used to raise cash or as a form of payment for the transfer of other assets such as intellectual property.

Types Of Options Contracts

There are two main types of stock options: exchange-traded options and over-the-counter options. An exchange-traded options contract applies to securities that are traded on a public stock exchange. An over-the-counter options contract applies to securities that are privately held and traded and do not go through any public exchange.

Options Trading

Just as the stocks of stock options contracts can be freely bought and sold on public markets, the options themselves can be bought and sold as well. Even if a stock options contract holder feels that the contract will prove profitable in the future, he or she may decide to sell it due to personal need for cash at the moment rather than in the future. Another issue may be the inability to capitalize on the contract: if the contract holder does not expect to have enough cash to purchase the stock at the strike price anyway, the contract is useless. A third reason may be that the contract holder does not have faith in the stock, expecting its value to fall below the strike price. In any of these cases, a stock options contract holder may usually sell the options on a futures exchange unless the contract restricts such action.

Types Of Options Trades

When it comes to stock options contracts, various basic types of trades exist.

  • If a trader thinks the market value of the stock will decrease, he or she may make:
    • a long put trade in which the trader buys the right to sell the stock at a certain price
    • a short call trade in which the trader sells the right to a potential buyer to purchase the stock at a certain price
  • If a trader thinks the market value of the stock will increase, he or she may make:
    • a long call trade in which the trader buys the right to purchase the stock at a certain price
    • a short put trade in which the trader accepts payment in return for agreeing to buy the stock at a certain price

Risk And Profit Potential

When parties buy and sell stock options contracts, they are essentially trading risk for profit potential or vice versa. In a long call/put trade, for example, the party selling the option seeks to offset the financial risks of the stock losing value by collecting a sum of cash immediately. However, in return for this alleviation of risk, the selling party loses the profit potential that would result from an appreciation in price, surrendering that profit to the buying party. Such trading helps the market to hedge around risks and allocate resources in the most effective manner.

If you are considering getting into the stock options game, make sure that you do all of your homework ahead of time. Buying and selling stock options contracts is a risky business. Do not do it without a full understanding of the risks involved.

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