What is an option agreement?
An option agreement is a legally binding contract between two entities describing the responsibilities of each counterparty towards the other.
Understanding the option agreement
There are several definitions of an option agreement in the financial and commercial environment. In general, an option agreement is an agreement between two individuals, companies or a combination of both, which defines the terms and conditions of each party.
In financial derivatives, the option agreement is a contract between two parties that grants one party the right, but not the obligation, to buy or sell an asset from the other party. It indicates the agreed price and a future date for the transaction. The premium corresponds to the selling costs and is invoiced by the subscriber. This type of option agreement is more common in the commodity markets.
The options are extremely versatile instruments. Traders use options to speculate. It is a relatively risky investment practice. When speculating, buyers and option writers have differing views on the performance prospects of an underlying security. Others use options to reduce the risk of holding an asset.
For most stock and futures options, buyers and sellers negotiate with each other indirectly on a formal exchange, which manages the clearing functions and reduces the risk of counterparty default. For all other options that are traded over the counter (OTC), the option contract will describe the remedies if one of the counterparties does not respect the terms of the contract.
Other types of option agreements
An option agreement can also be an agreement signed between an investor seeking to open an options account and his brokerage company. The agreement is the verification of an investor’s level of experience and knowledge of the various risks involved when negotiating option contracts. It confirms that the investor understands the Option Clearing Corporation (OCC) rules and that they will not present an undue risk to the brokerage. An investor must understand the options disclosure document, which highlights the terminology, strategies, tax implications and unique risks of the options before the broker allows the investor to trade options.
The agreement between an employer and an employee is also an option agreement. It sets the conditions for the employee’s stock option benefit. This agreement is also known as an incentive stock option agreement (ISO). With these employment options, the holder has the right, but not the obligation, to buy certain shares of the company at a predetermined price, for a specific period. These are incentives or rewards that the employee earns for good work and loyalty. Employees generally have to wait a specified vesting period before they can exercise the option on the company’s shares.
Another common option agreement is on the real estate market. The option agreement sets out the conditions under which a party will have the right to the first chance to purchase property at a specific price at a later date.