What Is an Option Contract?
Contracts to buy and sell come in all kinds of arrangements. One of the lesser-known varieties of contracts is known as an "option contract." In a typical option contract, the seller agrees to keep an offer open for a certain amount of time. A potential buyer has to give the seller some payment in exchange. In other words, in an option contract, the seller is agreeing to keep the "option" open for the buyer.
Option Contracts at a Glance
Option contracts are most commonly associated with the financial services industry, where a seller may option the opportunity to purchase stock at a certain price for a set period of time. By accepting a certain amount of money in exchange for this option, the seller has bargained away their right to revoke the offer. It's important to point out, however, that the party buying the option is under no obligation to actually exercise this option and purchase the stock, since he or she only bargained for the option to do so.
These kinds of contracts are also common in real estate, 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 her bank before fully committing. If the buyer agrees to the terms within the designated time period, then a binding contract is created for the deal.
The option expires at the end of the period stated in the contract, regardless of whether the buyer exercises the option.
The Usefulness of Option Contracts
At first glance, option contracts may seem unnecessarily complicated. However, option contracts are extremely useful in markets wherein prices fluctuate quickly. Consider this example:
Suppose you are an investor and you want to buy stock in a clothing manufacturer. You notice that prices for clothing producers are low, at $2.00 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 busy researching the clothing industry, the company you're researching gets featured in a popular fashion magazine and its 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.
Many employers offer option contracts as part of a benefit package. This is especially true of start-up companies. Employee option contracts often give the employees the option to buy company stock at a much reduced price. Both the company and the employee then hope that the company's stock rises quickly.
For more information on contracts and other arrangements, see FindLaw's Contract Law section.
Have More Questions About Option Contracts? Talk to an Attorney
Contracts are very important for businesses, and if drafted incorrectly, it can be a costly mistake. If you're planning to draft or sign onto an option contract (or any other kind of contract, for that matter), it's a good idea to have it reviewed by an experienced contracts attorney in your area.