Options Choices

If you're loking for an exciting and profitable way to trade the markets, Options Trading might be just what you're looking for!

An option is a contract giving the owner the right (but not the obligation) to buy or sell 100 shares of a given stock at a set price (called the strike price).

Options have two major defining characteristics: the expiration and the strike price.

Options expire every month, at the close of the market on the third Friday. With few exceptions, this is when all options for the month are closed out and redeemed.

The strike price is the value at which the contract guarantees a sale. For example, a call option with a strike price of $45 guarantees the buyer of the option that they may purchase 100 shares at $45 per share any time before the option expires, no matter how valuable the underlying stock becomes. For this right, the buyer pays what is called a premium.

The value of an option is determined by the current value of the underlying stock, the volatility or perceived risk of a change in value of the stock, the strike price, and the time left until the option expires.

If the strike price of a call option is less than the underlying security's current value, it is said to be "In-The-Money," meaning that if the option expired right at that moment, it could be redeemed for a gain.

A call option gives the owner the right to buy 100 shares of the stock any time before the option expires. Let's look at an example. Stock XYZ is currently trading at $46.82. A call option on XYZ that expires next month and has a strike price of $45, would have an intrinsic value of $1.82 per share (46.82 - 45.00). This means that if the option were exercised right now, one could purchase the shares at $45 and then immediately sell them for a profit of $1.82 per share. With several weeks left until the option expires though, the option might currently cost $2.70 per share. The extra $0.88 ($2.70-$1.82) is called the premium. How high the premium is depends largely on how much time is left until the option expires, and how much uncertainty exists as to if the price will make a large move.

A call option on the same stock with a strike price of $47.50 would currently have an intrinsic value of zero, since the strike price is more than the current value of $46.82. Even so, with several weeks to go, this call option with strike price of $47.50 might cost $0.55 per share. Since the intrinsic value is zero, the entire $0.55 is the premium ($0.55-$0.00).

As the value of the option declines relative to the price of the underlying stock, it’s called "time decay." The longer the amount of time until the option expires, the slower the decay, and that’s what you can take advantage of, by leveraging different types of options against each other.

So that's options trading in a nutshell. For more info, check out the great resources on this site, and download our free guide, "Option Trading: Thinking Outside the Box."

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