This article is written by Hrishika Rawat of BBA LLB, Banasthali Vidyapith, Newai (raj.). This article deals with the meaning of ption contracts with their features, advantages, and disadvantages. It also elaborates on how option contracts work.
It has been published by Rachit Garg.
Table of Contents
Introduction
Options are financial products that may offer you, an individual investor, the flexibility you want in nearly any investing circumstance. Alternatives provide you with options. You are not restricted to simply buying, selling, or keeping out of the market. You may customize your position to your specific scenario and stock market forecast by using options.
Consider the following choices’ possible benefits:
- You can protect your stock assets against a market price fall.
- You can enhance your income by selling some of your present stock holdings.
- You can plan to purchase stock at a lower price.
- Even if you don’t know which way prices will move, you may prepare for a large market change.
- You can profit from a stock’s increase or fall without paying the expense of purchasing or selling it.
A stock option is a contract that grants its holder the right, but not the duty, to purchase or sell shares of the underlying securities at a certain price on or before a defined date. The option is no longer available after the specified date. At the buyer’s request, the seller of an option is bound to sell (or purchase) the shares to (or from) the buyer of the option at the stipulated price.
What is an Option Contract
As options are a sort of derivative, their value is determined by the value of an underlying instrument. The underlying instrument might be a stock, but it could also be an index, a currency, a commodity, or any other type of investment.
Now that we know what options are, let’s look at what an options contract is. An option contract is a financial contract that grants an investor the right to purchase or sell an asset at a certain price by a certain date. It does, however, include the right to purchase, but not the responsibility to do so.
When it comes to understanding the meaning of an option contract, it is important to remember that there are two parties involved: a buyer (also known as the holder) and a seller (also known as the writer).
Modern options were born in 1973, with the establishment of the Chicago Board Options Exchange. On June 4, 2001, the National Stock Exchange (NSE) of India began trading in index options.
Types of Option Contracts
- Call Option
A call option, usually referred to as a “call,” is a financial contract between two people, the buyer, and the seller of the option. The buyer of a call option has the right, but not the responsibility, to purchase an agreed amount of a certain commodity or financial instrument (the underlying) from the option seller at a specific time (the expiration date) for a specific price from the seller of the option (the strike price).
If the buyer decides to sell the commodity or financial instrument, the seller (or “writer”) is compelled to do so. This right is purchased for a charge (known as a premium). The owner of the stock has the right to “call the stock away” from the seller, thus the name “call.”
When you purchase a call option, you are purchasing the right to purchase a stock at the strike price at any time before the expiration date, regardless of the stock price in the future. The seller, on the other hand, can short or “write” the call option, giving the buyer the right to acquire that stock from you at any moment before the option expires. To compensate you for the risk you took, the buyer gives you a premium, often known as the price of the call. The seller of the call is said to have shorted the call option, and he or she keeps the premium (the amount paid to acquire the option) whether or not the buyer exercises the option.
Let’s look at an example of a call option to better comprehend it. Assume an investor purchases a call option on a stock of XYZ business on a given day at a strike price of Rs 100, with an expiry date of a month later. If the stock price climbs over Rs 100 on the expiration day, say to Rs 120, the call option holder can still buy the stock for Rs 100.
- Put Option
A Put, also known as a put option, is a stock market mechanism that gives the owner of a put the right but not the obligation to sell an asset (the underlying) to a specific party at a predetermined price (the strike) by a given date (the expiry or maturity) (the seller of the put). The purchase of a put option is interpreted as a downgrade in the underlying future value. The ability of the owner to “put up for sale” the stock or index is referred to as a “put.”
Put options are most typically employed in the stock market to safeguard against a stock’s price falling below a certain level. If the price of the stock falls below the strike price of the put option, the owner/buyer of the put has the right, but not the obligation, to sell the asset at the specified price, whereas the seller of the put must purchase the asset at the strike price, if the owner uses the right to do so (the owner/buyer is said to exercise the put or put option).
Let’s look at an example to better understand what a put option is. Assume an investor purchases a put option on XYZ business on a specific date with the understanding that he can sell the investment for Rs 100 at any time before the expiration date. If the share price goes below Rs 100, say to Rs 80, he can still sell it for Rs 100. If the share price climbs to Rs 120, the holder of the put option is not required to exercise it.
Elements of a typical Option Contract
Options contracts include all of the elements of a standard contract, such as:
- A promise made by a promisor
- A promisee’s acceptance
- Consideration (this is the exchange of something of value for something else of value)
- Mutuality of parties
- Legal capacity for parties to enter into the contract
- Legally acceptable terms
In most cases, an options contract will also include the following extra elements:
- The fundamental security
- The sort of alternative (whether it is a call option or a put option)
- The contracting party’s commodity
- The date on which the contract takes effect
- The price of the strike
- The date of expiry
Features of Option Contracts
- Highly flexible
Because options contracts are highly standardized, they can only be exchanged on organized exchanges. Such choice instruments cannot be made flexible to meet the needs of both the writer and the user. There are, on the other hand, privately negotiated options that can be exchanged ‘over the counter.’ These instruments can be customized to meet the needs of both the writer and the user. As a result, it includes the characteristics of both ‘futures’ and ‘forward’ contracts.
- Down Payment
To exercise the option, the option holder must pay a fee known as a “premium.” This is regarded as the contract’s consideration. If the option holder does not exercise his option, he forfeits the premium. Otherwise, this premium will be subtracted from the total payment when computing the option holder’s net payoff.
- Settlement
When the contract is written, no money, commodity, or share is exchanged. In general, this option contract expires when the option holder exercises the option or when it reaches maturity, whichever comes first. As a result, settlement occurs only when the option bearer exercises his option. If the option is not exercised by the maturity date, the agreement immediately ends, and no settlement is necessary.
- Non-linearity
Unlike futures and forward contracts, options do not have the attribute of linearity. It signifies that the option holder’s profit when the underlying asset’s value moves in one way is less than his loss when it moves in the other direction by the same amount. In summary, earnings and losses in an option transaction are not balanced.
- No obligation to buy or sell
The option holder has the right to buy or sell an underlying asset in all options transactions. He may exercise this privilege at any moment throughout the contract’s term. In no instance, however, is he obligated to purchase or sell. If he does not purchase or sell, the contract just expires.
Purpose of an Option Contract
Options are often used for hedging, but they may also be utilized for speculating. Options are often only a fraction of the price of the underlying shares. Using options is a type of leverage since it allows an investor to wager on a stock without having to buy or sell the shares entirely. The option buyer pays a premium to the party selling the option in return for this right.
Traders usually employ options to hedge their positions. Options, on the other hand, can be utilized for speculating. This is because options are often just a fraction of the price of the underlying asset. Options may be used to gain leverage since they allow an investor to wager on a stock without having to acquire or sell the shares altogether.
How does it work
The following terms are included in an options contract:
- The expiration date of the contract
- The striking price, or the price at which an underlying asset can be purchased or sold
- The fundamental asset.
In general, call options may be purchased as a leveraged gamble on the appreciation of a stock or index. Put options, on the other hand, are typically purchased to benefit when prices fall.
Call option purchasers have the right but are not compelled to purchase the number of shares covered by the contract at the strike price. The inverse is also true: purchasers have the option, but not the obligation to sell their shares at the strike price specified in the contract.
Option sellers, on the other hand, must complete their side of any deal whether the buyer decides to execute the call option and acquire the underlying asset or execute the put option and sell the underlying asset.
Advantages of an Option Contract
Now that we’ve established what options are, let’s look at some of their advantages.
- Low cost of entry
When compared to stock transactions, the first benefit of options is that it allows the investor or trader to establish a position with a modest amount. When purchasing genuine stocks, you must pay a huge quantity of money equal to the price of each stock multiplied by the number of stocks purchased.
- Risk hedging
Options are a fantastic strategy to safeguard your stock holdings. Purchasing options are similar to purchasing insurance for your stock portfolio, reducing your risk exposure. If the underlying security price for a call option does not increase over the strike price before the option expires, your option becomes worthless, and you lose all of the money you paid upfront. The premium you finish up paying, though, is the maximum limit of your risk. In the previous example, if the price of a security falls to Rs 80 from a strike price of Rs 100, you would have lost Rs 20 per share. With the alternative, you just lose the premium amount, which is significantly less.
- Flexibility
Options provide the investor with the ability to trade for any prospective movement in an underlying investment. An investor can utilize an options strategy if he believes the price of a security will move shortly. If an investor believes that the price of a security will climb, he can purchase a call option and lock in the price of the asset at a specific level. If the underlying security’s price rises, he can buy it at the strike price and then sell it at the market price to profit. If, on the other hand, an investor believes that the price of a certain asset will decline, he can purchase a put option with a specific strike price. Even if the security’s price falls below the strike price, he can still sell it at the strike price and lock in a set price for selling it. As a result, options can be used in a variety of market scenarios.
Disadvantages of an Option Contract
Trading in options has several disadvantages. Let’s have a look.
- Lower liquidity
One of the major drawbacks of options is that they are not liquid since the options market is small. It is difficult to acquire and sell options due to a lack of liquidity. When compared to other more liquid investing alternatives, this frequently means buying at a higher rate and selling at a lower rate.
- Risk
As previously stated, the risk in the case of options is limited to the option premium. However, if the price movement of the asset is unfavourable, an investor risks losing the whole option premium.
- Complicated
Options are a tricky financial instrument for newcomers. Investing in options may be difficult even for experienced investors. One must predict the price movement of certain securities and the time frame in which this price movement will occur. It might be difficult to get both correctly.
What happens when an Option Contract expires
Each option contract will have an expiration date. That is, the contract’s value is strongly dependent on the date. Within this window, you have the option to purchase, sell, or exercise the contract. When an options contract expires, however, the contract is no longer valid.
Mistakes to be avoided while drafting an Option Contract
- Conduct an attorney evaluation
Contract law is one of those areas where an ounce of prevention is worth a pound of cure. We have clients that approach us regularly because they are involved in a contract dispute. When we examine the contract, sometimes it works in their favor; other times, important wording is lacking that greatly undermines their claim.
- Awareness of critical issues
Before I put pen to paper, I want to have my customers orally explain to me a general framework of the agreement so that they understand it. Typically, these are the topics that my clients are most concerned about, and I want to address them first. Next, before I begin drafting a contract, I want to discuss my ideas with my customer and get their feedback on my ideas. This assists both of us in becoming acquainted with the key topics.
- Be specific in your terms
Over the years, I’ve had several badly drafted agreements come across my desk that required to be reworked due to sloppy drafting. “The parties feel they can work out a parenting plan that is fair and reasonable,” for example, is a recipe for disaster. Do yourself a favor and be explicit with the conditions, you can always depart if you agree to do so as you proceed. Clarity is king in all things contractual.
- Investigate existing forms and templates
One size does not fit all when it comes to preparing legal papers and contracts. However, this does not exclude you from using pre-existing forms and templates to construct your papers. You must strike a balance between efficiency and client utility. In general, while writing papers, you must ascertain your client’s particular and subjective criteria and aims. With these in mind, you may begin to develop a broad paper, tailoring it to meet the unique demands of your customer.
- Proofread thoroughly
The most common error one encounters is due to inadequate copy-and-paste. Occasionally, it comes from a customer who copied provisions from something they discovered on the internet. As is usually the case with such contracts, there will be something that does not make sense or is detrimental to the customer in the context of their circumstances.
- Make a Memorandum
It is suggested to utilize the deal memo as a checklist for the initial contract writing after having produced hundreds (literally) of technology and entertainment business contracts throughout my 20-plus-year legal career. Then, as an intermediate and final phase in the contract negotiation process, cross-check your contract draft against the agreement memo.
- Verify thoroughly
Do your homework. Before you put ink to paper, get all of the facts necessary to verify what your counterparty is telling you. Without that knowledge, you risk overpaying, being taken for a ride, or being left holding the bag (depending on what’s at stake in the deal).
Sample of an Option Contract
[Company Name] [Stock Plan Name]NOTICE OF STOCK OPTION GRANT
[Optionee Name] [Optionee Address Line 1] [Optionee Address Line 2]You have been granted an option to purchase Common Stock of [Company Name], a Delaware corporation (the “Company”), as follows:
| Date of Grant: | __________ |
| Exercise Price Per Share: | USD$__________ |
| Total Number of Shares: | __________ |
| Total Exercise Price: | USD$__________ |
| Type of Option: | __________ Shares Incentive Stock Option__________ Shares Nonstatutory Stock Option |
| Expiration Date: | __________ |
| Vesting Commencement Date: | __________ |
| Vesting/Exercise Schedule: | So long as your Continuous Service Status does not terminate (and provided that no vesting shall occur following the Termination Date (as defined in Section 5 of the Stock Option Agreement) unless otherwise determined by the Company in its sole discretion), the Shares underlying this Option shall vest and become exercisable in accordance with the following schedule: __________ of the Total Number of Shares shall vest and become exercisable on the __–month anniversary of the Vesting Commencement Date and __________ of the Total Number of Shares shall vest and become exercisable on the __________ day of each month thereafter [(and if there is no corresponding day, the last day of the month)]. |
| Termination Period: | You may exercise this Option for [3] month(s) after the Termination Date except as set out in Section 5 of the Stock Option Agreement (but in no event later than the Expiration Date). You are responsible for keeping track of these exercise periods following the Termination Date. The Company will not provide further notice of such periods. |
| Transferability: | You may not transfer this Option except as set forth in Section 6 of the Stock Option Agreement (subject to compliance with Applicable Laws). [You must obtain Company approval prior to any transfer of the Shares received upon exercise of this Option.] |
By your signature and the signature of the Company’s representative or by otherwise accepting or exercising this Option, you and the Company agree that this Option is granted under and governed by the terms and conditions of this Notice and the [Company Name] [Stock Plan Name] and Stock Option Agreement (which includes the Country-Specific Addendum, as applicable), both of which are attached to and made a part of this Notice.
In addition, you agree and acknowledge that your rights to any Shares underlying this Option will vest only as you provide services to the Company over time, that the grant of this Option is not as consideration for services you rendered to the Company prior to your date of hire, and that nothing in this Notice or the attached documents confers upon you any right to continue your employment or consulting relationship with the Company for any period of time, nor does it interfere in any way with your right or the Company’s right to terminate that relationship at any time, for any reason, with or without cause, subject to Applicable Laws. Also, to the extent applicable, the Exercise Price Per Share has been set in good faith in compliance with the applicable guidance issued by the IRS under Section 409A of the Code. However, there is no guarantee that the IRS will agree with the valuation, and by signing below, you agree and acknowledge that the Company, its Board, officers, employees, agents and stockholders shall not be held liable for any applicable costs, taxes, or penalties associated with this Option if, in fact, the IRS or any other person (including, without limitation, a successor corporation or an acquirer in a Change of Control) were to determine that this Option constitutes deferred compensation under Section 409A of the Code. You should consult with your own tax advisor concerning the tax consequences of such a determination by the IRS. For purposes of this paragraph, the term “Company” will be interpreted to include any Parent, Subsidiary or Affiliate.
The company:
[Company Name]By:
(Signature)
Name:
Title:
OPTIONEE:
(Print Name)
(Signature)
Address:
Conclusion
An option is a contract in which the buyer is given the right, but not the obligation, to buy or sell an underlying asset. A call gives the holder the option to buy an asset at a specific price and within a given time frame. A put allows the holder to sell an asset for a set price on or before a certain date. The striking price of the underlying stock is the price at which it can be bought or sold. There are four types of players in the options market – holders, writers, buyers, and sellers. Holders are commonly used to describe buyers, whereas writers are used to describing sellers. An option strategy is a combination of buying and selling options that differ in one or more aspects at the same time, sometimes in a mixed manner. This is done as part of a trading strategy to get exposure to a certain type of opportunity or risk while avoiding other risks. A basic strategy would be to buy or sell a single option; however, option strategies typically involve a combination.
References
- https://www.thebalance.com/call-and-put-options-definitions-and-examples-1031124
- https://www.icicidirect.com/knowledge-center/article/advantages-of-options-over-futures
- https://www.investopedia.com/articles/active-trading/020216/five-advantages-futures-over-options.asp#:~:text=investor%20to%20understand.-,The%20Bottom%20Line,liquidity%2C%20and%20easier%20pricing%20model.
- https://www.thinktrade.net/options-advantages-and-disadvantages.php
- https://www.indiainfoline.com/knowledge-center/derivative-market/what-are-the-features-of-option
- Brenner, M., G. Courtadon, and M. Subrahmanyarn. 1985. “Options on the Spot and Options on Futures.” Journal of Finance (December): 130S17.
- https://media.orrick.com/Media%20Library/public/files/o/option-agreement.docx?__cf_chl_tk=bDsGlNvKVp075Wx.9sliWhv9Nnp7KKgdfwfllD0MyiI-1648409438-0-gaNycGzNB70
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