A Brief Introduction About the Option Contract
What Is an Option Contract?
When the buyer and seller of securities, commodities, or real estate decision that the purchaser can buy or sell the particular asset at a future date at an agreed price, they enter the contract.
What Does the Contract Mean?
If we look at a contract meaning, it says though the seller in the contract has agreed to sell their home, the transaction is still in the inspection or ‘option period.’
How Many Shares Are in the Contract?
Trading in options takes place through contracts, with each option providing the buyer with 100 shares.
Under the option contract law, the offeror (seller) cannot revoke the offer made to the offeree (buyer).
An example of the contract would be an over-the-counter option that takes place between two private parties. These include interest rate options and currency exchange rate options. A market-based fee is charged a premium. The buying price is known as the ‘strike price.’ The buyer also buys a put options contract where the buyer can sell the stock at a future date. The buyer would have to make a decision before the expiry date.
Who Takes the Option Contract – People Involved
The agreement is taken by the buyer and seller of assets where the buyer has the right to sell or buy the asset at an agreed price at a future date. These contracts can be found in commodities, securities, and real estate transactions.
These transactions ensure that the buyer hedges or protects their position by simultaneously buying and selling call (buy) and put (sell) options irrespective of the price movement of the stock.
Purpose of the Option Contract – Why Do You Need It
When it comes to assets, whether they are securities, real estate, or commodities, there is no certainty regarding their future value in financial terms. It is very difficult to predict if the movement of prices of such assets.
If you have invested in any security which is very volatile, there are chances that you might make a huge profit from it at a future date or a huge loss. You might feel that the security you have bought has the potential to give you superior returns, but your prediction may be wrong. You would have lost your principal investment.
With the help of such a contract, you can decide to buy the security at the current price or strike price at which it is trading and simultaneously enter into a contract where you can sell it at a future date at an agreed price.
When you enter into such a contract, you protect yourself from any adverse price movements in the asset. When you buy the asset with a call option, you freeze the price. So, when the price of the asset goes up at a future date, you pay to exercise the call option and buy the shares at the strike. The difference between the market price and the strike price is your profit.
Contents of the Option Contract – Inclusions
The agreement should contain all the details which relate to the transaction along with the details of the buyer and the seller.
Here are the contents:
- The effective date of the contract
- The names of the parties to the agreement, the buyer and seller
- The complete details of the asset being sold. In the case of real estate, the county, and the state in which the property is located.
- The seller will grant the buyer the exclusive rights to the property and the date by which the buyer needs to exercise the option to purchase needs to be mentioned
- Default by the purchaser: All the payments made by the purchaser to the seller shall be retained by the seller as liquidated damages, and the buyer’s right to purchase is terminated
- Title to the property: Within 15 days of the purchaser exercising the option to purchase the property, the seller needs to deliver the certificate of title to the buyer
- Purchase Price: The buyer needs to pay the option money and then the purchase price after receiving the title from the seller
- Extension of option: The extension of the option will take place by mutual consent and on payment of an additional sum to the seller
- Expenses of sale: The seller has to bear the cost of sale including the attorney’s fees and other expenses in connection with the preparation of the Warranty Deed and title certificate
- Possession: On closing, the purchaser will have the right to possession of the property
How to Draft the Option Contract – Points to Consider While Preparing the Agreement
While preparing a draft of the option agreement, the following points need to be kept in mind:
- Eligibility to contract: Both parties to the contract must be competent to contract. They should be of legal age, of sound mind, and not be under the influence of drugs or alcohol.
- Consideration for the option: The cost of the option has to be paid to the seller before the date of expiry. When the cost of the option is paid, the buyer can then purchase the stock at the strike price
- Contract terms: The contract should not be in favor of any particular party, and there should be no fraud or deception involved in the contract. The contract should be entered by both parties in good faith
- Confidentiality clause: The parties to the contract should not disclose any confidential information related to the contract to a third party
- Termination of a contract clause: If the buyer or seller wants to terminate the contract prematurely, then the notice period should be mentioned in the contract
- Governing law: The contract should be prepared in accordance with the applicable laws of the state relating to such contracts in place
- Reserving the last page for signatures and dates: Without the signature of both parties to the contract, the contract cannot be implemented. The signature implies that both parties have understood and agree with all the terms and conditions
Negotiation Strategy
The seller in the contract needs to state all the terms and conditions and place it before the buyer of the contract for acceptance of the same. The buyer has to ensure that the offer made by the seller is profitable, considering the fact that the purchase and sale of the option will take place at a future date.
Benefits & Drawbacks of the Option Contract
Here are the benefits:
- Protection of interest: The interest of both the buyer and seller of the option is protected. The buyer may exercise the opportunity if he feels it is going to profitable or let the contract expire. The seller will be paid the option price when the buyer decides to exercise the call option
- Lower chances of losses: With these contracts, the buyer is able to hedge or protect their position. If there is a possibility of the price of the underlying asset falling, the buyer can buy a put option where they will get the strike price irrespective of what the market price maybe
- Flexibility: When you sell a call option or a put option, then you have an obligation to deliver the security. When you buy a call or put option, you have the right but not the obligation to exercise your option
The drawbacks are below:
- No certainty of price movements: The future price of an asset cannot be predicted; it may rise or fall. You may invest in the asset and suffer great losses
- No protection: Without this contract, you cannot protect your investment by freezing the price of the security at a future date. When you invest directly in stock, then you have no backup like a call or put option to minimize your losses
[Also Read: Stock Option Agreement]
What Happens in Case of Violation of Option Contract?
There are remedies available to both parties to the contract in case of violation by one party.
They are:
- Money Damages: In this case, the injured party is entitled to compensation for financial losses suffered. The compensation would depend on whether it was a partial or a complete breach of contract. In case of a complete breach, the injured party would have to be compensated to the extent of the amount receivable had the contract been fulfilled, including lost profits.
- Restitution: Under restitution, the injured party has to be restored to the same position as they had before entering into the contract. The money or property received by the defendant has to be returned. This is usually resorted to when the other party is not competent
- Rescission: When a contract is entered into under fraud or undue influence, then such a contract is terminated, and both parties to the contract have no further contractual obligations.
- Reformation: This remedy is implemented by a court when they find there are inequities in the contract, where one party has some undue advantage over the other party. A fresh contract is prepared.
- Specific performance: Under specific performance, monetary compensation is not acceptable. This remedy is used when the contract has reached an advanced stage, and monetary damages are not adequate.
An option contract is an agreement that protects the buyer of the asset from financial losses. Since it is difficult to predict the movement of a security, this contract enables you to hedge or protect your investment by simultaneously entering into a buying and selling contract.
You can take your decision based on the price movement of the asset, but it has to be taken before the expiry date of the contract. You don’t need to pay the full price of the asset; you just pay the option price, which is a much smaller amount.
If you buy the call or put option, you have the right but are not under any obligation to sell the asset. Both parties to the agreement should ensure that the laws relating to drafting this contract have been followed. Otherwise, the agreement will be null and void. There should be a termination of the contract clause where the parties can prematurely end the agreement by serving a notice.