What Is an Option Contract?

An option contract is a legal agreement in which the seller agrees to keep an offer open for a specified period of time in exchange for payment, allowing the buyer the option to purchase or sell an asset within that time. Commonly used in financial markets and real estate, these contracts are beneficial for hedging against price fluctuations and securing favorable terms.

There are two main types of option contracts: call options, which allow buying at the strike price, and put options, which would enable selling. In financial services, option contracts can involve buying or selling stocks at a predetermined price, known as the strike price, before expiration. Option contracts are also used in employee benefit packages, particularly in start-ups, offering employees the chance to buy company stock at reduced prices.

Option Contracts at a Glance

One of the lesser-known types of contracts is an option contract. In a typical option contract, the seller agrees to keep an offer open for a certain amount of time. The buyer of the option has to give the seller some payment in exchange. In other words, in an option contract, the seller agrees to keep the "option" to purchase open for the buyer for a specified period.

Options trading contracts, a type of derivative, are most commonly associated with the financial services industry. A seller may have the opportunity to purchase stock at a certain price for a specified period of time. By accepting money in exchange for this option to buy the underlying stock, the seller has essentially provided a warranty that they won't revoke the offer.

It's important to point out that the party buying the stock option is under no obligation to exercise this option and purchase the underlying security since they only bargained for the option to do so.

These contracts are also common in real estate transactions where it may take a while for a potential buyer to conduct a full inspection of the property and secure funding, among other steps. In this case, the seller and the prospective buyer may agree on a certain amount, for example, but the buyer needs to meet with their bank before fully committing. If the buyer agrees to the terms of the contract, then a binding contract is created for the deal. They are also common in the formation of joint ventures.

The option expires at the end of the time frame stated in the contract, regardless of whether the buyer exercises the option.

Different Types of Option Contracts

There are two kinds of options contracts:

• Call options
• Put options

Call options give the holder the right to buy the underlying asset at a specified price, the "strike price," on or before the expiration date. The buyer of a call option hopes that the underlying asset's price will rise so they can profit by selling it at a higher price.

Put options give the holder the right to sell an asset at a specified price. The buyer of a put option hopes that the underlying asset's price will fall so that they can make a profit by buying it at a lower price.

When someone enters into an options contract, they are said to be long if they are buying a call option or short if they are buying a put option.

Option Contract Terms

An options contract includes terms that specify:

• The contract's expiration date
• The strike price
• The underlying asset

The Usefulness of Option Contracts

At first glance, option contracts may seem unnecessarily complicated. However, they are beneficial in markets where prices fluctuate quickly, a process known as hedging. They are also useful in the corporate world when companies issue special dividends in the form of options to their shareholders.

Suppose you are an investor and want to buy stock in a clothing manufacturer. You notice that prices for clothing producers are low, at $2 a share, but you still want to do some research into a particularly interesting company. So you pay the company a small amount of money, such as 2 cents per share, in exchange for their promise to sell you the stock at its current price anytime in the next three months. Failure to keep this option open is considered a breach of contract.

Two weeks later, as you're still researching the clothing industry, the company you're researching gets featured in a popular fashion magazine, and its stock price skyrockets to $50 per share. Fortunately, your option contract is still in place, and you can still buy the stock for only $2 per share. Thanks to your clever planning, you've just bought a $50 stock for a total cost of $2.02 per share, a huge difference in market value.

Options contracts provide advantages for both the seller and the buyer of the option in such an instance. The seller in an options contract receives a payment regardless of what happens with the underlying stock or security. The buyer of the option gets to lock in their right to acquire the underlying contractual asset at a favorable price while putting up a small amount of money.

Many employers offer option contracts as part of a benefit package. This is especially true of start-up companies. Employee option agreements often allow employees to buy company stock at a much-reduced price. Both the company and the employee hope the company's stock rises quickly.

See FindLaw's Contract Law section for more information on contracts and other arrangements.

Have More Questions About Option Contracts? Talk to an Attorney

Contracts are very important for businesses. If drafted incorrectly, they can be a costly mistake. Solid legal advice is essential if you're planning to draft or sign an option contract (or any other kind of contract, for that matter). It's a good idea to have your contract reviewed by an experienced business law and contracts attorney in your area.