Options Contracts

• A stock option is a contract that gives the buyer the right, but not the obligation to buy or sell the stock it is written on for a specific price on a specific date in the future. They are called options contracts because the buyer is given an option to exercise the contract.
  
  

Exercising an Options Contract

• Options can be best understood by example. If you own a contract that gives you the right to buy a stock for $100 when the stock is trading for $110 on the open market, it makes sense for you to exercise your option to buy, since you can turn around and sell the stock to someone else for a $10 profit. If, however, the stock is trading at $90, it does not make sense for you to buy for $100. In this instance, you would not likely exercise your option.
  
  

Futures Contracts

• When you buy a futures contract, you buy an obligation to take delivery on a basket of goods at a specific date in the future at a price agreed upon today. Futures contracts are typically written on baskets of commodities, such as gold, silver, oil and farm products, but they can also be written for stock indexes, such as the S&P 500.
  
  

Insurance Against Future Price Risk

• Futures and options can be used against future price risk. A stock owner may buy an option contract that will allow him to sell at a specific price if the stock price declines. If the price declines, he knows he will still be able to sell the stock for the price stated in the contract. Futures are similar. For example, a farmer may buy a contract that guarantees the price she will receive for her crops once they are harvested. Regardless of what the market is willing to pay for her crops at the time of harvest, she knows she can sell them for the price stated in the contract she owns.