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Options Basics
What is an option?
An option is a contract based on an underlying asset, such as a stock or index. Options give the buyer certain rights, while the seller accepts certain obligations. The two main types of options are calls and puts.
What is a call option?
A call option gives the buyer the right, but not the obligation, to buy the underlying asset at a specific price before or at expiration, depending on the option type.
Example:
If a trader buys a call option with a $100 strike price, that call becomes more valuable if the underlying stock rises above $100.
What is a put option?
A put option gives the buyer the right, but not the obligation, to sell the underlying asset at a specific price before or at expiration, depending on the option type.
Example:
If a trader buys a put option with a $100 strike price, that put may become more valuable if the stock falls below $100.
What is a strike price?
The strike price is the price at which an option can be exercised. It is one of the most important parts of an options contract.
Example:
A $100 call option gives the buyer the right to buy at $100, even if the current price is above $100. A $100 put option gives the buyer the right to sell at $100, even if the current price is below $100.
What is an expiration date?
The expiration date is the date when the option contract expires. After expiration, the option no longer has value or rights attached to it.
Example:
A weekly option may expire this Friday. A monthly option may expire on the third Friday of the month.
What is intrinsic value?
The difference between the stock price and an In The Money strike price.
Example:
If the stock of a call contract with a strike price of $100 is trading at $105, the intrinsic value is $5. If it were trading at $95, there is no intrinsic value.
What is extrinsic value?
The value of the amount of time left until expiration.
Example:
If the stock of a call contract with a strike price of $100 is trading at $95, the intrinsic value is $0 but the contract could still be valued at $1. This represents the value of time.
What does In The Money mean?
When the stock trades above the strike price, the call option contract has an intrinsic value equal to the difference between the current price and the strike price.
Example:
If the stock trades at $110, a call option with a strike price of $100 has an intrinsic value of $10.
What does Out of The Money mean?
When the stock trades below the strike price, the call option contract has an intrinsic value of $0.
Example:
If the stock trades at $90, a call option with a strike price of $100 has an intrinsic value of $0.
What does At The Money mean?
When a stock trades at the strike price.
Example:
If the stock trades at $100 and the strike price of an options contract is also $100, it is considered At The Money.
What is option premium?
Premium is the price paid or received for an option contract. Buyers pay premium. Sellers collect premium.
Example:
If an option trades for $1.50, one contract usually represents 100 shares, so the premium would be $150 before commissions and fees.
Key takeaway
Options are contracts with specific terms: underlying symbol, call or put, strike price, expiration date, and premium. Understanding these pieces is essential before learning options strategies.