An options contract is an agreement that allows a trader to buy or sell an asset at a predetermined price or on a specific date. Options contracts are available in various assets; they are adjustable to different markets like stocks or digital currencies. These contracts are based on economic indicators and are designed to reduce the risk of buying and selling and trading based on speculation.
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How option contracts work
There are two types of option contracts:
Puts and calls and both of them could be purchased to speculate on the orientation of the securities or cover. They can also be sold to generate revenue.
It is clear that if traders guess that the price of a stock or anything else will go up, they will enter into an options contract and vice versa, if they estimate that the price will go down, they will enter into an options contract. Investors may enter into these contracts in the hope of price stability. Or utilization of a combination of these two types to trade in order to bet in the opposite direction or in the direction of market fluctuations.
An option contract has at least 4 different sections: size, expiration date, target price and reward.
- Size refers to the number of contracts to be traded.
- The expiration date is the date after which the investor cannot make changes to the desired option.
- The target price (strike price or transaction price) is the price at which the asset will be bought or sold (if the buyer of the contract decides to apply the contract)
- A premium is the setting of an option contract and determines the amount of money the investor needs to close the contract.
Buyers receive contracts from sellers according to the amount of reward set for the contract, and the important point is that the closer we get to the expiration date, the more the reward changes.
Simply put, if the target price of a contract is lower than the current market price, a trader can buy the asset in question and, by adding a bonus amount, may decide to apply the contract to make a small profit. On the other hand, if the target price is higher than the market price, there is no reason to execute the contract and the contract becomes useless. If the contract is not used, the buyer will lose only the amount of money intended for the reward.
It should be noted that the buyers of a contract are able to execute or not execute a contract, yet the fate of the contract sellers depends on the decision of the buyers.
Therefore, if a call option buyer decides to execute his contract, the seller of the contract is forced to sell the asset. Similarly, if a trader buys a contract and decides to execute it, the seller is obligated to buy the asset from the contract holder.
This illustrates that contract sellers are more at risk than buyers; since buyers may only lose the reward amount but, sellers lose more due to market prices. Some contracts allow their owners to execute it before the expiration date and are referred to as US option contracts. On the other hand, the European option contract is only valid on the expiration date.
The difference between an option contract and futures
Options and futures contracts are both financial instruments, yet despite their similarities, there are some differences.
Unlike the option, in future contracts, the contract is executed when the expiration date arrives. This means that in futures contracts, the contract holders are required to exchange the desired asset (or its cash equivalent).
However, the options or transaction is exercised only at the discretion of the contract holder. If the option contract holder executes it, the seller is obliged to trade the desired asset.
Options expiration time importance
Since you can no longer trade an options contract after it expires, it is important for all traders to know when the option expires. Remember, buying an options contract means that you are purchasing the right to buy or sell the assets offered in the contract at a predetermined price and within a certain period of time.
When the contract reaches the end of the specified time (its expiration date), unless the buyer chooses to exercise the right, the contract expires and becomes worthless. For a seller of an option contract, this can be a pleasant event, as expired options contracts are the ideal result for many options strategies, such as the “Iron Condor Credit Spread”. Yet, for the buyer of options, the expiration of the ignored option can equate to a trading loss.
Do options expire in open or closed time?
According to NASDAQ, the options technically expire at 11:59 a.m. Eastern Standard Time on the expiration date, which is oddly enough on a Sunday. However, the general holders of options contracts must declare their willingness to trade no later than 5:30 pm on the business day before the expiration date. Most stock options follow a predetermined expiration system. US stock options always expire on the Saturday after the third Friday in the month. An exception occurs in the case of market holidays, in which case the expiration on Thursday is just before Friday.
For holders who need to notify the exchange of their intention to trade, it is important to know that notice limits (for how long you can notify) vary depending on where the product is traded. For instance, the Chicago Board of Options Exchange (CBOE), requires expiration options to be traded by 3:00 pm (Central) on the third Friday of the expiration month.
Most contract traders do not hold the option until the expiration date. Instead of practicing it or letting it expire, they get out of position. Traders should consult with their broker about expiration, as some brokers will have different information restrictions.
Understand the expiration time
Expiration time should not be confused with expiration date. The expiration date is the last time the holder exercises the option, meaning that the exercise notice must be received on that date to be effective. That is, the intention of the holder of that option must be specified on or before the expiration date.
It should be noted that the time and expiration date when investors apply through brokerage can vary. The times can be from half an hour to a few hours earlier to give the broker the opportunity to fulfill his client’s request. The difference between the two depends on the broker and their set of rules. Finally, it gives the broker the opportunity to issue an exchange notice to the intended holders of the transaction before the expiration date. Also, times can vary depending on which exchange this option is traded on.
Most options contracts never reach their expiration date since traders close their positions before such time. Options that are alive until they expire have more conditions than those that do not.
In a nutshell
The options trading allows the investor to buy or sell in the future regardless of the price of a particular asset. These contracts are very flexible and are used in different scenarios. Options contracts not only for speculative trades but also it is often used to reduce the risk of transactions.
Needless to say, option contracts, like other instruments in trading and financial markets, carry a lot of risks so there should be a fixed time when options contracts expire.
In addition to all this, it should be said that investors should use risk control tools and fundamental and technical analysis in combination with this trading system in order to have the least loss and the most profit from their assets.