What is an Option?

For equity options, the underlying instrument is a stock, ETF or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon.

Contracts also have an expiration date. When an option expires, it no longer exists.

Options come in two varieties, calls and puts. You can buy or sell either type. You decide whether to buy or sell and choose a call or a put based on objectives as an options investor.

Buying and Selling

If you buy a call, you have the right to buy the underlying instrument at the strike price on or before expiration. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, the option holder has the right to sell the option to another buyer during its term or to let it expire worthless.

The situation is different if you write or sell to open an option. Selling to open a short option position obligates the writer to fulfill their side of the contract if the option holder wishes to exercise.

When you sell a call as an opening transaction, you're obligated to sell the underlying security at the strike price, if assigned. When you sell a put as an opening transaction, you're obligated to buy the underlying security, if assigned.

As a writer, you have no control over whether or not a contract is exercised, and you must recognize that exercise is possible at any time before expiration. However, just as the buyer can sell an option back into the market rather than exercising it, a writer can purchase an offsetting contract to end their obligation to meet the terms of a contract provided they have not been assigned. To offset a short option position, you would enter a buy to close transaction.

At a Premium

When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn't fixed and changes constantly. The premium is likely to be higher or lower today than yesterday or tomorrow. Changing prices reflect the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point of agreement becomes the price for that transaction. The process then begins again.

If you buy options, you begin with a net debit. That means you've spent money you might never recover if you don't sell your option at a profit or exercise it. If you do make money on a transaction, you must subtract the cost of the premium from any income to find net profit.

As a seller, you begin with a net credit because you collect the premium. If the option is never exercised, you keep the money. If the option is exercised, you still keep the premium but are obligated to buy or sell the underlying stock if assigned.

The Value of Options

The worth of an option is determined by market participants when buyers and sellers agree on a price.

A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option. The call option is out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price. A put option is out-of-the-money if its underlying price is above the exercise price. If an option is not in-the-money at expiration, the option is assumed worthless.

An option's premium can have two parts: an intrinsic value and a time value. Intrinsic value is the amount that the option is in-the-money. Time value is the difference between the intrinsic value and the premium. In general, the longer time that market conditions work to your benefit, the greater the time value.

Options Prices

All market participants affect the price of an options through the process of supply and demand where buyers and sellers come together creating best bid/ask of all bids and offers.

The status of the overall markets and the economy at large have many contributing factors. Influences include company specific news, global macro news, and volatility.