Option Agreement

Key takeaways

• An option agreement (options contract) grants the buyer the right, but not the obligation, to buy or sell an underlying asset at a preset strike price before or at a specified expiration date.
• Two main types: call options (right to buy) and put options (right to sell).
• Options can be used for hedging, speculation, or income generation, but they carry risks such as time decay and potential total loss of the premium.
• Option value depends on the underlying price, strike price, time to expiration, volatility, interest rates and dividends.
• Standard equity option contracts typically represent 100 shares.

What is an option agreement?

An option agreement is a financial derivative between two parties that sets the terms for a potential future transaction in an underlying security (stocks, ETFs, indexes, currencies, etc.). The buyer pays a premium for the option and receives a right:
* Call option — the right to buy the underlying at the strike price.
* Put option — the right to sell the underlying at the strike price.

The seller (writer) receives the premium and is obligated to buy or sell the underlying if the buyer exercises the option.

How options work

An option contract specifies:
* the underlying asset,
* the strike price,
* the expiration date,
* the contract size (commonly 100 shares for U.S. equity options).

Buyers may exercise the option (if favorable) or trade the contract before expiration. Options provide leverage: a relatively small premium controls a larger notional exposure to the underlying. However, options are wasting assets—their time value erodes as expiration approaches (time decay).

American-style options can be exercised any time before expiration; European-style options can only be exercised on expiration date.

Calls and puts — basic mechanics

• Call buyer: pays a premium for the right to buy at the strike price. Maximum loss is the premium paid; upside is potentially large depending on the underlying’s rise.
• Call seller (writer): receives the premium and must sell the underlying at the strike if assigned. A covered call writer owns the underlying and thus limits downside risk relative to a naked writer.
• Put buyer: pays a premium for the right to sell at the strike price. Used to profit from declines or to insure long positions.
• Put seller: receives the premium and must buy the underlying at the strike if assigned, exposing the seller to downside.

Options are often used in combination with ownership of the underlying (e.g., covered calls, protective puts) or with other options to form spreads and more complex structures.

Common uses and strategies

Hedging
* Protective put: buy the underlying and buy a put to limit downside exposure while preserving upside potential.
* Covered call: own the underlying and sell a call to generate income, at the cost of capping upside.

Speculation
* Buying calls to leverage an expected rise in price.
* Buying puts to profit from an expected decline.

Income and spreads
* Selling options to collect premiums (requires careful risk management).
* Spreads (bull/bear spreads, straddles, strangles, butterflies, calendar spreads) combine multiple options to shape payoff, limit risk, or exploit volatility and time decay.

Strategy selection should match market outlook, time horizon, and risk tolerance.

Risks and benefits

Benefits
* Leverage: control more exposure for less capital than buying the underlying.
* Defined downside for option buyers: loss limited to premium paid.
* Flexibility: can be used to hedge, speculate, or generate income.

Risks
* Time decay: option value decreases as expiration nears if underlying does not move favorably.
* Total loss: options can expire worthless if out of the money.
* Volatility sensitivity: option prices can swing widely with volatility changes; higher volatility generally raises premiums.
* Assignment risk: sellers may be assigned and required to transact at the strike price, potentially incurring large losses (especially for uncovered positions).

Examples

Leverage example
* Stock price: $100. Buy 100 shares costs $10,000.
* Buy one at-the-money call with $100 strike expiring in one month at $2 premium = $200.
If stock rises to $120:
* Owning 100 shares yields ~$2,000 profit.
* One option contract (100 shares) would be worth roughly $2,000 less the $200 premium, netting ~$1,800 on a $200 outlay.
Scaling the option position with the same capital magnifies returns but also magnifies risk of losing the entire premium if the stock fails to move.

Basic covered-call example
* Stock trading at $60. Sell a $65 call with one-month expiration.
* If stock remains below $65 at expiration, the seller keeps the premium and the shares.
* If stock rises above $65, the seller may be assigned and must sell the shares at $65, foregoing further upside.

Other derivatives and alternatives

Options are one family of derivatives. Others include futures, forwards, and swaps, each with distinct mechanics and risk profiles. Natural hedging—structuring a portfolio so gains in one asset offset losses in another—can reduce reliance on derivatives.

Practical considerations

• Match option expiration to expected timing of the underlying’s move.
• Monitor implied volatility—high implied volatility increases premiums.
• Have an exit plan: define conditions to sell, exercise, or adjust positions.
• Use risk controls for sellers (margin requirements, position limits) and avoid uncovered positions unless fully understood.

Bottom line

An option agreement provides flexible ways to manage exposure: hedging downside, leveraging directional views, or generating income. Their effectiveness depends on understanding option mechanics, pricing drivers (time, volatility, underlying price), and the risks involved. With proper education and risk management, options can be a powerful addition to an investor’s toolkit; without them, options can result in significant losses.