What is an options contract?

What is an options contract?

An options contract is a financial instrument that gives you the right, but not the obligation, to buy or sell an underlying asset at a set price – known as the strike price – on or before a set expiry date. There are two types of options contracts:

There are two types of options contracts:

1. 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
2. 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.

We offer you two ways to trade options:

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

An options contract is known as at-the-money when the underlying price is the same as the strike level, in-the-money when there's profit opportunity between the underlying and strike price and out of the money when there is no profit potential between the underlying and strike price. In the money options have both intrinsic and extrinsic value. At the money and out of the money options purely have extrinsic value.

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. Strike levels 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 trading platform.

How can you trade options?

Trade options in just six steps:

1. Learn more about options trading
2. Choose between US-listed options and OTC options
3. Create an account
4. Choose an options market to trade
5. Decide between daily, weekly or monthly options
6. Select a strike price and position size
7. Open, monitor and close your trade

When you trade listed options with us, you’ll be able to choose from a range of underlying assets and enter actual options contracts. For OTC options, you’ll be trading actual option contracts through a spread betting or CFD account. This gives you exposure to options without entering the standardized exchange-traded options market. It's important to note that while these options are traded via spread betting or CFD platforms, they are distinct from spread bets or CFDs themselves.

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 Apple (AAPL) stock is going to fall from the current market price of $150. So, you decide to buy a monthly AAPL put option with a strike price of $145. The premium (or buy price) for this option is $3 per share.

Since one standard US-listed option contract represents 100 shares, your total cost (and maximum potential loss) is $300 (100 shares x $3 premium). This amount is deducted from your account when you buy the option.

Scenario 1: price falls

The price of AAPL subsequently falls, with the stock trading at $135 at the time of expiry. This means the option is 'in the money' by $10 per share ($145 strike - $135 current price).

Value at expiration: $1,000 (($145 - $135) x 100 shares)

Initial premium paid: $300

Total profit: $700 ($1,000 - $300)
Scenario 2: price rises

However, say the price of AAPL increased instead, closing at $155 at expiration. Your option would expire worthless, and you would have lost the $300 premium you paid to open the trade.

Options contracts summed up

• Options contracts give you the right, but not the obligation, to buy or sell an underlying asset at a set price – known as the strike price – on or before a set expiry date
• US-listed options are standardised contracts traded on regulated exchanges, primarily for stocks, ETFs and indices
• OTC options offer more flexibility in terms and underlying assets but may have different risk profiles and liquidity compared to USOF
• 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 potentially 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 spread bets and CFDs

Open a trading account to trade live spot prices, or create a demo account to practise trading in a risk-free environment.