Option Contract

An Option Contract is a financial agreement that gives the buyer the right, but not the obligation, to buy or sell an underlying asset—like a stock—at a predetermined price within a specific timeframe. Think of it as a reservation coupon. You pay a small fee (the premium) for the choice to act later. If you want to buy the asset, you have a Call Option. If you want to sell the asset, you have a Put Option. The predetermined price is known as the strike price, and the deadline is the expiration date. The seller of the option, on the other hand, has the obligation to fulfill the contract if the buyer decides to exercise their right. This creates an asymmetric relationship: the buyer's potential loss is limited to the premium paid, while their potential profit can be substantial. For the seller, the potential profit is limited to the premium received, while their potential loss can be significant, even unlimited in some cases.

Options come in two basic types, each serving an opposite purpose:

• Call Option: This gives you the right to buy an asset at the strike price. You'd buy a call if you believe the asset's price is going to rise. Imagine putting a non-refundable deposit on a house you think will increase in value. The deposit gives you the right to buy the house at today's price later on. If the market booms, you exercise your right and get a bargain. If it slumps, you walk away, losing only your deposit.
• Put Option: This gives you the right to sell an asset at the strike price. You'd buy a put if you believe the asset's price is going to fall. Think of it as an insurance policy for your stocks. If you own 100 shares of XYZ Corp. and worry about a market crash, you could buy a put option. If the stock price plummets, your put option allows you to sell your shares at the higher, locked-in strike price, protecting you from losses.

Every option contract is defined by four main components:

• Underlying Asset: The “what.” This is the financial product the option is based on, most commonly a stock, but it can also be an ETF, an index, or a commodity.
• Strike Price: The “how much.” Also known as the exercise price, this is the fixed price at which the underlying asset can be bought (with a call) or sold (with a put).
• Expiration Date: The “when.” This is the date the option contract becomes void. The owner must exercise their right on or before this date. European-style options can only be exercised on the expiration date, while American-style options can be exercised any time up to the expiration date.
• Premium: The “cost.” This is the market price of the option contract itself, which the buyer pays to the seller to acquire the rights of the option.

While options can be powerful, they are a double-edged sword. For a value investing purist, who focuses on buying great companies at fair prices for the long term, most uses of options fall squarely into the realm of speculation, not investing.

The vast majority of options traders lose money. Why? Because options are a decaying asset. Their value is eroded by a powerful force called time decay. Every day that passes, an option becomes slightly less valuable, all else being equal. This means that for your bet to pay off, you don't just have to be right about the direction of the stock price—you have to be right within a specific, and often short, timeframe. Most options expire worthless, making the sellers rich and the buyers poor. Furthermore, options are a type of derivative, meaning their value is derived from the value of another asset. This adds layers of complexity and risk that can be treacherous for inexperienced investors.

That said, a disciplined value investor can use options conservatively as a tool to manage risk or generate extra income on their existing holdings.

A covered call involves selling a call option on a stock you already own. In exchange for the premium you receive, you agree to sell your stock at the strike price if the buyer exercises the option. This is a popular strategy to generate a small, steady income stream from your portfolio. The trade-off? You cap your potential upside. If the stock price soars far above the strike price, you'll miss out on those extra gains.

A protective put is essentially portfolio insurance. As mentioned earlier, you buy a put option for a stock you own. It costs money (the premium), which will be a drag on your returns if the stock price goes up or stays flat. However, if the stock price collapses, the put option allows you to sell your shares at the strike price, putting a floor under your potential losses. It's a way to hedge against catastrophic downside risk.

Imagine your favorite band announces a concert. Tickets are €100. A scalper believes the concert will sell out and demand will be huge. Instead of buying a ticket directly, the scalper pays a “reservation fee” of €10 to the venue. This fee gives him the right, but not the obligation, to buy one ticket for €100 anytime in the next month.

• This is a Call Option: The scalper is the option buyer. The venue is the option seller.
• Underlying Asset: The concert ticket.
• Strike Price: €100.
• Premium: The €10 reservation fee.
• Expiration Date: One month from now.

If the band's popularity explodes and last-minute tickets are selling for €300, the scalper exercises his option. He buys the ticket from the venue for the locked-in €100 price and immediately sells it for €300. His profit is €300 (sale price) - €100 (strike price) - €10 (premium) = €190. However, if the lead singer gets sick and the concert's hype fades, last-minute tickets might drop to €50. The scalper's right to buy a ticket for €100 is now worthless. He simply lets the option expire. His total loss is limited to the €10 premium he paid for the right. He didn't have to buy the €100 ticket and lose even more. This perfectly illustrates the limited risk and high potential reward for an option buyer.