An option is simplay a contract. There are two types of options, calls and puts. A call gives its owner the right to purchase a stock at a certain price before its expiration date. A put gives its owner the right to sell a stock at a certain price before its expiration date. Every option contract controls 100 shares of stock.
Contract Components
A call has the following components:
- Underlying stock. The stock that is controlled by this option.
- Strike price. The price at which the call owner is entitled to buy shares of a stock.
- Expiration date. The date when the option becomes worthless.
- Seller. This person has an obligation to sell the stock at the strike price if the call is ever exercised.
- Buyer. This person has the right to buy the stock at the strike price until the expiration date has passed.
- Premium. The call buyer pays the seller a premium in order to obtain this right.
A put has the following components
- Underlying stock. The stock that is controlled by this option.
- Strike price. The price at which the put owner is entitled to sell shares of a stock.
- Expiration date. The date when the option becomes worthless.
- Seller. This person has an obligation to buy the stock at the strike price if the put is ever exercised.
- Buyer. This person has the right to sell the stock at the strike price until the expiration date has passed.
- Premium. The put buyer pays the seller a premium in order to obtain this right.
Premium
An option’s premium is composed of two parts.
- Intrinsic value. If a stock is currently selling at $30, a call option with a $25 strike price has $5 of intrinsic value. This is because at any time you can exercise the option to buy the stock at $25, then sell it in the market for $30. If the value of the stock goes below $25, this option’s intrinsic value goes to 0.
- Time value. The time value of the stock is derived from the amount of time left to expiration, the volatility of the stock, and various market conditions. An option’s time value usually drops slowly over time until the final weeks before expiration when it drops very rapidly.
In the Money, At the Money, and Out of the Money
These terms refer to where the strike price of the option is relative to the price of the stock. If an option has intrinsic value, meaning that for a call the strike price is below the price of the stock and for a put the strike price is above the price of the stock, the option is considered to be in the money. If the option does not have any intrinsic value, it is considered to be out of the money. Note that an out-of-the-money option still has some value - that is the time value of the option. The strike price that is closest to the current price of the stock is called at the money. The at-the-money option usually has the most time value of any of the options for that stock.
Bid and Ask
There are two prices quoted for each option, the bid and the ask. The ask, or asking price, is the price you have to pay to buy the option. The bid is the price you get if you sell the option. The spread between the bid and ask can be anywhere from one cent on up to 50 to 60 cents or more. Five to ten cents is pretty typical for a fairly liquid option. You must be very careful with illiquid options with large bid/ask spreads because it can make it very difficult to exit a position profitably.
Exiting an Option Trade
After you have bought an option, there are two things you can do with it.
- Exercise the option.
- For calls, this means you want to buy the stock at the strike price. You must have enough money to buy the amount of stock that is controlled by the options you are exercising.
- For puts, this means you want to sell the stock at the strike price. You must have stock available to sell in order to receive the money.
- Sell the option.
- You can choose to sell an option at any time before its expiration. If the stock has moved in a favorable direction (up for calls, down for puts), the option could be worth more than what you paid for it, and you can sell it for a profit. Most people trade options in order to sell them, not to exercise them.
