Defining an Option Contract
An option contract is a type of agreement that gives an individual or entity the right but not the obligation to do something. The two most common types of option contracts are for the purchase of stock in a corporation, and real estate. While option contracts can be helpful in a variety of professional settings, it is essential to make sure that the document is legally enforceable.
An Option Contract for Real Estate
When executed properly, an option contract for real estate gives the option holder the right to purchase the property at a given price within the timeframe of the agreement. There are two main types of option contracts used in real estate, which are much the same as other contracts:
1. An option to purchase (when a buyer may purchase the property).
2. An option to lease (when a tenant may lease the property).
A good example of an option contract is executed when a business purchases an option to buy real estate. At that point , the business is able to buy the property so that a different business can move in. This can be beneficial because it allows the business to secure the location before the business is ready to commit.
Another example of an option to purchase is the case in which a builder obtains an option on the land so that residential condos can be built.
An option to lease is commonly used when an individual wants to rent a home, such as while they are traveling for business or otherwise out of an area for an extended period.
In either case, the individual or entity is bound by the contract to execute their end of the deal if the option is exercised within the given time frame.
An Option Contract for Stocks
An option contract for stock is an agreement that obligates the seller of a security to deliver that security to the purchaser. The buyer is not obligated to purchase the security. Typically, it is a stock or bond, although stocks are more commonly agreed upon than others for an option contract. The buyer pays for the right to purchase the securities, but not the obligation when the option expires. If the buyer does not buy the securities before the expiration, the seller keeps the money paid for the option contract.
Core Components of an Option Contract
A contract is an agreement between parties, which creates legally binding obligations. An option contract is a contract whereby an offer is made by one person to another, which remains open for acceptance, during the time specified, or, if no time is specified, within a reasonable time. The vendor cannot withdraw the offer during this time, but is usually required to keep to the terms of that offer, as a vendor (party making the offer), because he has been paid a deposit by the purchaser, in order to secure the purchase, and should keep that sum of money separately and not spend it, in order to prevent him profiting from the deposit if the purchaser chose not to take up the option.
The key elements that are required for an option contract to be in force are as follows: Offer: for an agreement to be prepared correctly, all of the terms and conditions must be available to the parties involved when entering into the agreement. Once the agreement is entered into by both parties, it is very difficult to entrench new clauses into the contact and for it to be binding. An example of terms and conditions, would be the price and the location of the property in question, without these terms and conditions, there is no agreement that can be prepared. Once an offer is accepted, a contract is created.
Acceptance: once all the terms and conditions are available to the parties, there must also be a verbal or written acceptance of the offer for the agreement to come into effect.
Consideration: is defined as something of value that is given in exchange for something else that is of value. In respect of a property transaction, consideration is generally the purchase price and is the same for all parties as the contract is prepared. In respect of an option contract, the purchaser pays the vendor a small fee to preserve their right to purchase the property at a certain price, within a certain period of time.
Specific conditions: are any terms or conditions that are not set out in the standard form of contract that is prepared. An example of this might be that the purchaser says they will only purchase the property if the price is below a certain threshold, or if the property has three bedrooms instead of two or if the purchaser wants to purchase as a joint venture with another party.
Anyone purchasing property should always enlist the help of a legal professional to ensure that the agreement is prepared correctly and covers the specific needs of the parties as well as the general terms and conditions that any property transaction would have.
Types of Option Contracts
Call Option Contracts: A call option gives an individual or business the right, but not the obligation, to purchase at a specified price (the exercise price) an asset, such as shares of stock, during a specified period of time. For example, a call option might be for 100 shares of ABC Corporation, at $10 per share, exercisable anytime over the next twelve months. If during that year the price of ABC shares rise to $15 each, the investor who purchased the call option can buy those shares at the agreed upon exercise price of $10. This can have the effect of guaranteeing that the investor acquires ABC shares at a set price, despite any increase in the market price of the shares over the twelve month period. Like all options, call options are not always exercised and can also be traded prior to expiration.
Put Option Contracts: A put option is similar to a call option, but gives the holder the right to sell, rather than buy, the underlying asset, at a specified price during a specified period of time. Using the example above, a put option might be for 100 shares of ABC Corporation, at $10 per share, exercisable during the next twelve months. If at any time during that year the price of ABC shares fell to $5, the investor who purchased the put option can sell her or his shares of ABC and therefore realize a guaranteed price of $10 per share. Like a call option, a put option is not always exercised, but can sometimes be beneficial to an investor who believes the price of the underlying assets may fall sharply. Actually exercising a put option and selling the underlying asset can protect an investor by eliminating any "paper losses" that results from a decline in the market value of their holdings.
Example of an Option Contract: A Comprehensive Analysis
For the purposes of this illustrative example, let’s say you own 100 shares of XYZ Corp., which you purchased at $30 per share (XYZ Corp. is a real publicly traded company but the following example is fictional for illustration purposes only). You think it is likely that the price of XYZ shares will fall significantly over the next two months due to upcoming disappointing earnings reports, but then rise again after the bad news has come out, so you would like to buy some put options allowing you to sell the shares back to the seller for a fixed price, rather than risk having to sell them on the open market at a lower price.
The most logical choice under the circumstances would be to buy a put option that grants you the right to sell your XYZ shares back to the buyer for a fixed price in two months (the expiration date). Assume that the following assume that each contract covers 100 shares and that XYZ is currently trading at $28.
Agreement terms:
Expiration Date: 60 days, which means it expires on January 18
Strike Price: $29 per share
Option Premium: $1.20 per share, which means you pay $120 for 100 shares
Settlement: The payment of the exercise price ($29 per share) minus the premium ($1.20 per share). If you were to exercise the option, the amount the seller would owe you is ($29-$28) * 100, or $1000.
If XYZ Corporation is trading above the strike price on January 18, then you can sell the call option on the open market and recover the cost of the option that way. If the price of XYZ is lower than the strike price on January 18, you are not obligated to sell the stock to the seller of the contract and you simply let the contract expire (like an insurance contract, where if the event does not occur, you do not receive anything). If you did want to sell the contract, then the amount you receive from the buyer is the strike price (29) minus the current market price (say 27), or $2 per share.
Keep in mind though that this is a simplistic example and in reality the pricing can be quite complex. The option premium would reflect considerations such as the volatility of the underlying share price (as well as the volatility of the broader market), dividend yield, borrowing interest rates, the risk-free rate of return and the time to expiration (for example, 60 days in this situation).
Here’s an example of how this transaction might play out.
Scenario 1: Good Call (or put) Option for You:
On January 18, two months after you purchased this put option, the market price of XYZ shares has declined to $25 per share. You exercise your option to sell the shares back to the seller for $29 per share. Your profit is therefore ($29-$28) * 100 = $1000, which you could immediately reinvest in the stock.
Alternatively, the option could have increased in value over the term such that you did not need to exercise the option (you could have simply sold the option on the open market). Assume it sold for $5 per share. This is because the seller of the put must expect that the price of XYZ to go up since he is obligated to buy the stock, and therefore the renewal premium would reflect this. The net effect would be that you would have realized a gain of (500 – 120) = $380 ($500 from the sale of the stock and $120 from the option premium, less the $2880 (100 x 28) you paid to buy the shares initially) from this transaction.
Scenario 2: Not Such a Good Call (or Put) Option for You:
It is January 18 and the amount you receive from exercising your option is $0 because the current market price has risen higher than the strike price and there is no profit in the transaction. In fact, you would be assuming a loss of at least $120. You would have the choice of selling the option on the market (in this case, for $0) or letting it expire worthless. Assuming the option expires, your total loss on the transaction would be the amount you initially paid for the option premium ($120).
Key Legal Considerations in Option Contracts
One of the key considerations in drafting or entering into an option contract relates to whether the option is enforceable. The enforceability of an option contract depends on its compliance with consumer protection legislation. If a court finds that a contract is not enforceable, it may be possible to argue for an equitable remedy, although this may require irrevocable steps to have been taken by the potential vendor.
If a variation is made to the contract, the option may lose its enforceability. This could possibly occur even if you merely change the contract price, length of time for compliance or a date, such as the settlement date, but do not add or subtract any of the other essential elements of the contract. The Vendor Discharge Notice provisions have complicated matters.
The risk regarding the vendor discharge notice is that consumers may be able to terminate an option contract after they have incurred expenditure to secure the option . For example, if some or all of the costs associated with an option (such as legal fees, building inspection costs, pest inspection costs, strata searches, etc) are incurred after an option is granted, the risk may be that a consumer may be able to terminate the option by serving a notice on the option giver and recover the costs they have incurred. Although it is likely that a consumer exercising an option would have incurred at least most of the costs at that stage, if a vendor has any concerns about the enforceability of an option, it may be preferable for them to serve the notice confirming the payment of the option consideration and the option price within the option period. This may reduce the risk of a consumer being able to terminate the contract and obtain a refund of their costs.
Common Pitfalls and How to Prevent Them
Common Pitfalls and Avoidance Tips
While option contracts have the potential to work much like a regular real estate purchase and sale agreement, they frequently do not and often lead to ensuing litigation. Parties should be mindful of the following common pitfalls in option contracts and ways to avoid them.
Parties may be confused as to the time period that must pass prior to the exercise of an option, assuming one is even available. As stated above, an option contact may be similar to a real estate purchase and sale agreement with a specific date to settle on or before. But if the purchase and sale agreement has been kept silent about the deadline for exercise, the law says that that deadline is reasonable time. A reasonable time period is the same as a reasonable distance or a reasonable height. Ask yourself, is a reasonable time the same throughout the year or can you think of times when "reasonable" is different? Do you think the same thing is reasonable in June as is in December? It is no different for time. The meaning of timeperiods and deadlines may stretch and can be very different at different times of the year.
Therefore, it is critical for the parties to be precise. This is how non-lawyers get in trouble. If you are not certain, consult your lawyer.
The parties may not be able to agree upon a price. Small business, particularly contractual arrangements between businesses, sometimes involve short term leases for land with an option to purchase the land at a later date if the business is successful. It is important to know at what point the price will be established. Will the price be market value when the option is exercised or will it be locked in when the option is signed? Does it depend on the parties’ agreement to agree later, or is it governed by a formula?
The parties may delay in their performance. If one party fails to perform within a reasonable time, the other party may be able to declare a default and require the first party to perform or part with his rights or property. Parties should plan to protect themselves from this later problem. Failure to perform will arise when one party has completed all that he was contractually obligated to do, and the other party refuses to deliver a deed or proceeds in exchange for the performance of the first party. When both parties have had an equal opportunity to complete performances and one has performed while the other has not, the second party is in default and is subject to the consequences of non-performance.
To illustrate this, consider the situation of a farm where A (the seller) has lived alone for a long time, and has no close relatives. He decides to sell 50 acres of his farm to B (the buyer) for $500,000, which is the fair market value. They agree on the price, but there is no money down. A prepares to convey the property and hires a skilled lawyer, while B represents himself. After several years of negotiations, B works with another buyer to buy the property for $900,000. With a sales contract in hand, B tells A he is unable to complete the contract. A does not want to sell to B because he does not trust B to deal fairly anymore. A says that he was deceived by B and would not have entered into the option unless he had known that it would later be used only to get a better price from another buyer. Before we can answer the question of whether A breached the option contract, we need to look at the agreement.
The time is…
Technology is great. But don’t let it get you in trouble. Emailing back and forth about the relevant terms and conditions can be confusing, particularly when the messages suddenly disappear and you can no longer find them. Caution: messages in the trash can remain there for as long as 30 days. To prevent confusion and to avoid message loss, draft a formal document that includes all the terms and provisions that you agreed upon. And — here’s a secret — avoid acronyms and internet slang. It’s always better to spell out your meaning than to assume that everyone understands what you mean.
Real World Applications: Option Contracts in Various Industries
To show the practical application of option contracts, I’ve listed below a few examples from the real world:
Real Estate – A developer seeking to build an apartment complex submits a bid for the land where he wants to build on the condition that the seller grant him an option to buy the land if his bid is accepted. Once he purchased the option and had it recorded, the developer then sought to rezone the land, install infrastructure, and obtain all necessary permits (a process that may take years). To avoid having to keep paying renewal fees on the option, the developer will usually exercise the option after the complex work is done.
Stock Markets – A stockholder seeking to sell his shares can enter into an option contract where he receives a premium up front. If the market price for the stock goes down , the option can be sold to another party who has a greater risk tolerance, probably at a lower premium than the original stockholder received.
Mergers and Acquisitions – In some merger contracts there is a clause that if the deal does not happen within a certain time frame, the other party must pay a negotiated breakup fee, or penalty; this may also be construed as an option contract. The penalty could take the form of a retention agreement, compensation for withdrawing a going-private offer, or loan payments. This type of option contract provides security to the other party that they will receive something in the event the contemplated deal doesn’t happen.