Options Trading 101

What are Options?

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (known as the strike price) on or before a certain date (known as the expiry date).
In return for this right, the buyer pays a payment (the premium) to the seller.

There are two types of options: CALL Option and PUT Option.

A call option gives the buyer the right to buy the underlying asset at the pre-determined strike price;
a put option gives the buyer of the option the right to sell the underlying asset at the pre-determined strike price.

An Example

For instance, consider the IBM stock, which is currently trading at around $117. If John is bullish on the stock, he can choose to buy a Sep 09 $120 CALL option for about $0.80.

The following are the terms used to describe the option:

Type of Option: CALL
Strike Price: $120
Expiry Month: Sep 09 (Options will expire on the 3rd Fri of the expiry month)
Premium: $0.80

A Sep 09 $120 CALL option will allow John to buy the IBM stock at $120 anytime before the option expires, regardless of how much IBM is currently trading at. A Sep 09 option will expire on the 3rd Friday of the month, which is 18th Sep 2009. After the 18th, if John chooses not to exercise his right (i.e. buy the stock at $120), the option will become worthless (i.e. expire).

[If he is wrong]
If suppose John is wrong and IBM does not move above $120 by 18th Sep 2009, all he loses is $80 ($0.80×100 = $80, since 1 Lot = 100 Units).

[If he is right]
If however, John is right and IBM rises above $120 to, say $130; he can now buy the stock at $120, pocketing a profit of ($130 – $120)*100 = $1000. After accounting for the premium he paid for the option, his profit will still be an awesome $920.

The Value of An Option

Time Value vs Intrinsic Value

The value of an option consists of two main components, its intrinsic value and its time value.

The intrinsic value of an option is the “real” value of the option. For call options, this is the difference between the underlying stock’s price and the strike price. For put options, it is the difference between the strike price and the underlying stock’s price. In the case of both puts and calls, if the respective difference value is negative, the instrinsic value is given as zero.

For instance, if AAPL (Apple) is currently trading at $160, a $150 CALL option will have an intrinsic value of $10 ($160 – $150). That is because the option allows its owner to buy the AAPL stock at a $10 discount. Put in another way: If the option expires today, it will be worth $10.

However, if the option does not expire today, it will be worth more than $10. This is due to the potential that AAPL can trade higher than $160. In return for the potential of a greater gain, an option buyer will have to pay more for the option. More likely, if AAPL is trading at $160, a $150 CALL option that expires in a few weeks time may be worth about $14, the additional $4 is known time value. Thus, time value is simply the difference between option value and intrinsic value.

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