What is an options contract?
Options contracts are popular derivative products that are used to speculate on markets and hedge against risk. Find out how they work and how you can trade options contracts.
What is an options contract?
An options contract is an agreement that gives you the right, but not the obligation, to exchange an asset at a set price – known as the strike price – on a set expiry date.
There are two types of options contracts:
- Call options – these give the holder the right, but not the obligation, to buy an asset. You’d buy a call option if you believe the market price will rise from its current level, and you’d sell a call option if you think it will fall
- Put options – these give the holder the right, but not the obligation, to sell an asset. You’d buy a put option if you believe the market price will fall from its current level, and you’d sell a put option if you think it will rise
When you buy an options contract, you’d pay a premium to open the trade. This premium is the most you would lose, as you can let the contract expire worthless. However, when you sell options contracts, your downside risk is potentially unlimited.
When you trade options with us, you’ll be speculating on the underlying market price using CFDs. This enables you to go both long and short without having to entering an options contract. You’ll be able to trade on a wide range of markets including forex, shares, stock indices and commodities.
How do options contracts work?
Options contracts work by tracking the underlying price of a market and enabling you to take a position without having to take ownership of the asset. The value of an options contract at the point of expiry will depend on how much the market has moved in your favour.
There are a few concepts that you’ll need to know to understand how options contracts work, including:
- The strike price
- Intrinsic value
- Maturity date
The strike price is the level at which an options contract can be exercised – it’s a fixed price that cannot be changed once the position has been opened. An options contract only has a value once the strike price has been met – known as an at-the-money option – or surpassed – known as an in-the-money option. Before this, the option has no intrinsic value and is out of the money.
The difference between the strike price and the underlying market price is called the intrinsic value of an option. For call options, the intrinsic value is calculated by subtracting the strike price from the underlying. For put options, the intrinsic value is calculated by subtracting the underlying price from the strike price.
The maturity date of an option is the last day on which it can be exercised. The nearer to its date of expiry, the less chance market movements will have a dramatic impact on the intrinsic value of the asset. For example, if an option is in the money an hour before its maturity, it’s unlikely that it will be out of the money at expiry.
The strike price, intrinsic value and maturity of an options contract will all affect how expensive the premium of that option will be. Options contracts that are closer to the current market price, with nearer points of maturity, will be more expensive than those further away.
Learn more about what moves options prices
You can find out the premium of an option, as well as its corresponding maturity date and strike price by looking at the options chain in our platform.
How can you trade options?
Trade options in just six steps:
- Learn more about options trading
- Create an account
- Choose an options market to trade
- Decide between daily, weekly or monthly options
- Select a strike price and position size
- Open, monitor and close your trade
When you trade options with us, what you’ll be getting is a CFD position on the underlying options market. This means you’ll get exposure to the market, without having to enter an options contract.
Example of an options contract
You thought the price of US crude oil would rise from $38 to $45 a barrel over the next few weeks. You could buy a call option that gives you the right to buy the market at $40 a barrel at any time within the next month. You’d pay a premium for this right.
Working example of trading an options contract
You believe that the price of US Crude is going to fall from the current market price of 3800 (that’s $38 per barrel, as the oil price is typically quoted in cents). So, you decide to buy a monthly US Crude oil put option with a strike price of 3350. The buy price for this option is 50 – this is referred to as the option’s ‘premium’.
One CFD is equivalent to an exposure of $10 per point, giving you a total exposure (ie maximum loss) of $500 (50 points x $10). This amount is set aside in your account as margin (equivalent to £383 in a sterling-denominated account, at the time of writing).
The price of US Crude subsequently falls, with the underlying settling at 3150 at the time of expiry. This means the option is ‘in the money’ by 200 points, giving it a value of $2000 (200 points x $10). Factoring in the initial premium paid ($500), the total profit on this trade comes to $1500 ($2000 - $500).
However, say the price of US Crude increased instead. Your option would expire worthless, and you would have lost the $500 (£383) you used to open the trade.
Options contracts summed up
- An options contract is an agreement that gives you the right, but not the obligation, to exchange an asset at a set price – known as the strike price – on a set expiry date
- There are two types of options contract: put and call
- When you buy options, your risk is limited to the premium you pay to open the position
- When you sell options, your risk is unlimited
- Options contracts track the price of an underlying market
- The value of the contract depends on how far the market price moves beyond your chosen strike price – or rather, how much intrinsic value the option has at expiry
- The intrinsic value and date to expiry will impact how expensive the premium is to open an options trade
- You can trade options contracts via CFDs
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