Options come in two primary forms:Calls and Puts
A call option gives the holder the right, not the obligation, to buy 100 shares of the underlying stock at a fixed price and for a fixed period of time.
A put option gives the holder the right, not the obligation, to sell 100 shares of the underlying stock for a fixed price and for a fixed period of time.
This is why an option is considered to be a "wasting" asset. Since the option only has value for a fixed period of time, its value decreases, or "wastes" away with the passage of time.
In the case of an index option, the holder can participate in the movement of the index. However, these options are cash settled and therefore, the holder of the option will never wind up with a position in the underlying securities.
The Four Components to an Option
There are four components to an option. They are: The underlying security, the type of option (put or call), the strike price, and the expiration date.
Let"s take an XYZ November 100 call option as an example. XYZ is the underlying security. November is the expiration month. 100 is the strike price (sometimes referred to as the exercise price). And the option is a call (the holder has the right, not the obligation, to buy 100 shares of XYZ at a price of 100).
Types of Expiration
There are two different types of options with respect to expiration. There is a European style option and an American style option.
The European style option cannot be exercised until the expiration date. Once an investor has purchased the option, it must be held until expiration. An American style option can be exercised at any time after it is purchased.
Today, most stock options which are traded are American style options. And many index options are American style. However, there are many index options which are European style options. An investor should be aware of this when considering the purchase of an index option.
The Parties to an Option
There are two parties to an option. There is the party who buys the option; and there is the party who sells the option.
The party who sells the option is the writer. The party who writes the option has the obligation to fulfill the terms of the contract should it be exercised. This can be done by delivering to the appropriate broker 100 shares of the underlying security for each option written.
At-the-Money, In-the-Money, Out-of-the-Money
There are three different terms for describing where an option is trading in relation to the price of the underlying security. These terms are "at-the-money," "in-the-money," and "out-of-the money."
Let's use our XYZ November 100 call as an example. If XYZ stock is trading at a price of 100, the November 100 call is considered to be trading "at-the-money." If XYZ stock is trading at a price greater than 100, say 102, the call option is considered to be "in-the-money." And if XYZ is trading at a price less than 100, say 98, the call option is considered to be trading "out-of-the-money."
Conversely, if it was an XYZ November 100 put option we owned, if the price of XYZ stock was 102, the put option would be considered to be out-of-the-money." And if XYZ stock were trading at a price of 98, the put option would be considered to be trading "in-the-money." If XYZ stock were again trading at 100, the put option would be "at-the-money."
Intrinsic Value and Time Value
Intrinsic Value
The price difference between the underlying security and the option's strike price is the intrinsic value.
For example, let's take that XYZ November 100 call. If XYZ is trading at 102, and the call option is priced at 2, the intrinsic value is 2. If an XYZ November 100 put is trading at 3, and the price of XYZ stock is trading at 97, the intrinsic value of the put option is 3.
If XYZ stock were trading at 99, an XYZ November 100 call would have no intrinsic value. And conversely, if XYZ stock were trading at 101, an XYZ November 100 put option would have no intrinsic value. An option must be in-the-money to have intrinsic value.
