12 Important Terms You Should Know in an Option Contract

An option contract places you in control. It allows you to buy or sell at a predetermined price within a defined time frame without being obligated to do so. What this means is that you lock in opportunities on your own terms, minimizing risk while retaining options. 

So, an option contract is what exactly? 

In simple terms, it's a contract that provides the opportunity for you to buy or sell something at a predetermined price in a specified period of time. 

You're not obligated to do anything; you have the right to make a decision at your convenience. 

But if you are to utilize them correctly, you have to know the way they work. 

In this blog, we will cover 12 important terms that will lead you to mastery of option contracts. 

Types of Options Contracts

There are two primary forms of options contracts: Call options and Put options, both for different uses. 

A Call option provides the purchaser with the right (but not the obligation) to purchase an asset at a predetermined price before the contract matures. Individuals use call options when they anticipate that the price of the asset will rise. 

A Put option, however, grants the right to the buyer to sell an asset at a specified price prior to expiration. Put options are useful when you anticipate the price of the asset to fall. 

Now, let’s break down the 12 most important terms you should know about option contracts. 

Option Holder 

The option holder is the one who gets to make the decision. When you purchase an option contract, you're paying for the right, but not the requirement, to buy or sell something at an agreed price within a specified time frame. 

This makes you flexible and in charge of your decision without being compelled to do anything unless it's in your interest. 

Whether you are handling stocks, property, or business deals, being the option holder gives you an advantage in terms of strategy. 

There is always an expiration date with every option contract, and if you do not take action before it, your chance goes away. The trick lies in knowing when to act. 

Option Writer 

An option writer is the individual on the other side of the transaction. They are the sellers of the option contract and receive the premium as payment. Unlike the option holder, who can choose to act, the option writer has a responsibility to carry out the contract if the holder exercises their option. 

This is a job with benefits and a price. The benefit? The writer is paid upfront, with or without exercise of the option. If the option goes unused, they have the entire premium as profit. But the catch? If the market turns against them, they are contractually obligated to act on the provisions of the contract, even at a loss of money. 

Strike Price  

The strike price is the center of any option contract. It's the agreed-upon price at which the option holder is able to purchase (in the case of a call option) or sell (in the case of a put option) the underlying asset. This is the price that makes the option worth something or nothing when it comes time to exercise it. 

Why does it matter? Because the strike price determines where gains or losses are made. If you have a call option, you hope that the market price goes above the strike price so that you can purchase at a discount. If you have a put option, you hope the market price drops below the strike price so that you can sell for a higher rate. 

Premium  

The premium is what you pay for the privilege of having a choice. When you purchase an option contract, you're paying for flexibility - the right to buy or sell an asset at a predetermined price in the future. This flexibility has a price, and that price is the premium. 

For the holder of the option, the premium is the sole risk. They can exercise the option and realize a profit if the market works in their favor. If it does not, they just allow the option to lapse, incurring only the premium paid originally. 

For the writer of the option (the seller), the premium is the profit. They receive this fee for agreeing to be obligated to complete the contract if the holder exercises their option. If the option expires without being used, the writer retains the full premium as profit. 

Expiration Date  

Each option contract has an expiration date, and that is what distinguishes options from buying and holding an asset. The expiration date is the cutoff date by which the option holder has to make a decision: use it or lose it. 

Why is this important? Because the longer you wait, the value of the option can shift radically. The nearer you are to the expiration date, the less time there is for the market to move in your direction. This is referred to as time decay, the gradual erosion of an option's value as the clock ticks away. 

Call Option  

Call options are usually purchased by investors who anticipate a price rise. When the market price crosses the strike price, the holder can exercise the option and purchase at a cheaper rate, making an instant profit. If the price doesn't go up, they can allow the option to expire and forego the benefits, only losing the premium paid initially. 

On the other hand, the option writer (seller) is obligated to sell the asset when the holder exercises the option. For this obligation, they receive the premium. When the option lapses unused, they retain the premium as profit. 

Put Option  

A put option is the right, but not the obligation, of the holder to sell an asset at a predetermined price (the strike price) prior to the expiration date. You can use it when you anticipate the price of the asset to decline, enabling you to sell at a better price than available in the market. 

Why do individuals purchase put options? Protection. When you hold an asset and you are afraid of its value to decrease, a put option behaves as an insurance policy. In case the price drops below the strike price, you can continue selling at the predetermined price without suffering a larger loss. Investors also utilize put options to earn money from dropping markets without physically holding the asset. 

Exercising an Option  

Exercising an option is nothing more than acting on the rights granted by the option contract. If you are a call option holder, exercising involves purchasing the asset at the strike price. If you are a put option holder, exercising involves selling the asset at the strike price. 

The majority of traders don't really use their options. They sell the option itself for a profit before it expires instead. This is because selling an option is easier than actually selling or buying the underlying asset. 

Assignment of Option  

If you've written (sold) an option, assignment is when you have to complete your part of the agreement. This occurs when the option holder exercises their option, compelling the seller to purchase or sell the underlying asset at the strike price agreed upon. 

For call options, assignment is that the seller would have to sell the asset at the strike price, even when the market price is much more. For put options, assignment is that the seller would have to purchase the asset at the strike price, even when the market price is much lower. 

Contract Consideration in Option Contracts  

All contracts require something of value transferred between the parties in order to be legally enforceable. In option contracts, that "something valuable" is the premium, the payment the buyer makes to the seller for the privilege of purchasing or selling an asset at a specified price. Without this payment, the contract would not stand. 

Consideration is what binds both parties. The writer (option seller) gets the premium and, in exchange, is bound to fulfill the contract if the buyer chooses to exercise. 

Legal Enforceability  

For an option contract to be upheld legally, it must fulfill a few conditions: offer, acceptance, consideration, and definite terms. Without any one of these, the contract is unlikely to stand in court. 

First, there needs to be consideration and acceptance. The seller presents the option, and the buyer accepts the conditions. Then there is consideration, in most cases, a premium, which needs to be exchanged. This is what transforms the agreement into more than a mere understanding. 

Then, there is clarity. An option contract should have clear details such as the strike price, expiration date, and underlying assets. 

Breach of an Option Agreement 

A breach occurs when the option writer (seller) defaults on the agreement terms such as withdrawing from a contract prior to the expiration period after being paid the premium. It may also result if the option holder (buyer) attempts to enforce an option that was not executed appropriately. 

If there is a breach, the non-breaching party can sue. This is the reason why a well-written and clear option contract is important. If both parties know clearly what their rights and obligations are, conflicts are less likely to arise. 

Final Thoughts 

Tracking expiration dates, strike prices, and contractual obligations can very quickly become more than one can handle without having the proper system in place. 

That is where a Microsoft 365-based contract management system comes in. 

Regardless of whether you are dealing with a handful of option contracts or dealing with an intricate portfolio, having the right system in place prevents anything from falling through the cracks. 

Ready to gain control of your option contracts with ease? 

Ask for a free demo today and discover how our solution can make contract management easy while staying ahead of deadlines and obligations. 

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