- There are two basic types of options that can be purchased and sold. A call option is a contract that grants the buyer the right, but not the obligation, to buy shares of a company at a specific price over a certain period of time. Put options are contracts that grant the buyer the right, but not the obligation, to sell shares at a set price. In both cases, options that do not reach the "strike price" by the expiration date expire worthless. A contract represents 100 shares of stock. An option's expiration date is generally the third Friday of the contract's expiration month in the American system. The American system allows exercise at anytime until expiration. The European system only allows conversion at expiration.
- When you purchase an option you pay a premium, which is the total price paid for an option above its strike price. Options have intrinsic value, or the difference between the underlying stock's price and a call option's strike price. Options also have extrinsic value, also known as timer value. Options are usually priced according to the Black-Scholes model, which takes into account three features: the length of time to maturity, the recent volatility of the stock, and the distance above or below the strike price.
- There are several ways to make money trading options. An option buyer often has conviction about the future direction of an underlying stock. Options give him greater leverage and therefore greater profit potential. If he's right, he can profit by selling the option for more than he paid, or by exercising his right to buy or sell the stock at a specified price. Many options traders prefer to be "writers" of options. These traders collect premiums from option buyers and then assume the obligation (risk) of buying or selling the underlying at the strike price.
- When an underlying stock or other instrument trades above a call option's strike price, that option is said to be "in the money" and exercisable in the American system. Likewise but opposite, when the underlying trades beneath a put option's strike price, that option is in the money. For example, if you purchase a 40 call option on company XYZ, and its stock trades at 41, your option is "in the money." But that same option would be considered "out of the money" when the stock is trading at 39.
- There are numerous options-trading strategies but typically they fall into two camps: those done by the option buyer and those done by the option seller. Option-buying strategies aim for quick moves in the underlying that minimize time decay. Option-selling strategies rely on time decay and benefit when the underlying moves away from an option's strike price or trades sideways. Combinations of both are quite common and are used for intermediate strategies (to either hedge or increase a position) as the option price approaches maturity.