Options Contract

An options contract is a derivative that gives its buyer, or holder, the right, but not the obligation, to buy or sell an underlying asset at a fixed price, called the strike or exercise price, on or before a specified expiry date. A right to buy is a call option; a right to sell is a put option. The buyer pays a price, called the premium, to the seller, or writer, who takes on the obligation to sell or buy if the holder chooses to exercise.

Options are written on shares, stock indices, currencies, interest rates, commodities, futures contracts and cryptocurrencies. They are used to hedge risk, to speculate with limited downside for the buyer, and to generate income for the writer.

Contracts giving the right to buy at a set price have existed for centuries, and options on shares traded informally in Amsterdam, London and New York long before modern exchanges. The modern era began in 1973, when the Chicago Board Options Exchange opened as the first exchange to list standardized options with central clearing. The same year, Fischer Black and Myron Scholes published their option pricing model, extended by Robert Merton, which gave traders a consistent way to value options and helped the market grow rapidly.

Each contract specifies the underlying asset, the quantity, the strike price, the expiry date, whether it is a call or a put, and the exercise style. American-style options can be exercised at any time up to expiry; European-style options only at expiry. Exchange-traded options are standardized and cleared by a central counterparty, while over-the-counter options, common in foreign exchange and interest rates, are negotiated between banks and clients.

An option's premium has two parts. Intrinsic value is what the option would be worth if exercised now: for a call, the amount by which the market price exceeds the strike. Time value reflects the chance that the option will become more valuable before expiry and depends heavily on the expected volatility of the underlying. Strategies built on writing options are a way of selling volatility.

An investor buys a call option on 100 shares with a strike price of 50 and pays a premium of 3 per share, or 300 in total. The notional amount is therefore 5,000. If the share price at expiry is 60, the investor exercises, buys at 50 and gains 10 per share, or 1,000, minus the 300 premium, for a net profit of 700. If the share price is 45, the option expires worthless and the investor loses only the 300 premium. The writer's position is the mirror image: it keeps the 300 premium in the second case, but in the first it loses 700 net, and its potential loss on an uncovered call is theoretically unlimited.

• Hedging. A company expecting foreign currency receipts can buy a put on that currency to protect against a fall while keeping the benefit of a rise, unlike a forward contract, which fixes the rate in both directions. This complements operational methods such as a natural hedge; see also hedging.
• Speculation. Buying options gives leveraged exposure to price moves with a loss capped at the premium.
• Income. Investors write covered calls on shares they own to collect premiums.
• Embedded options. Many financial products contain options, such as the right of a borrower to repay a loan early or the conversion feature of a convertible bond.

Option buyers can lose their entire premium, and many options expire worthless. Writers face potentially large losses and must post collateral, which can trigger a margin call if prices move against them. In the United States, options on securities are regulated by the Securities and Exchange Commission, while options on futures and commodities fall under the Commodity Futures Trading Commission. Crypto markets offer options alongside instruments such as perpetual futures, often on platforms outside these regimes.

In Islamic finance, conventional options are generally considered impermissible by most scholars and standard-setters, on the grounds that a right sold separately from an asset involves excessive uncertainty, or gharar, and can resemble gambling, or maysir. Some Islamic institutions use promises, known as wa'd, to achieve comparable hedging outcomes.