Options Basics
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An option is a contract whereby the author of the contract, known as the "writer," promises to buy or sell a specific quantity of a security at a particular price. For example, an option may be created that obligates the writer to buy 100 shares of Microsoft stock at $50 per share. In exchange for this contractual promise, the buyer of an option makes a payment to its writer. This payment is known as the option's premium value, and is the source of profit for the option's author.
Exercising an Option
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The muscle of an option is its exercise right. This right is granted to the current owner of the option and is the means through which the option's author may be forced to engage in the transaction detailed by the option itself. While this right sounds powerful, and it is, there is a caveat: All options are written with an expiration date attached. Once that date arrives, if the contract has not already been exercised by the current owner, it becomes worthless and the author is no longer obligated by the contract.
It is important to understand that the owner of the contract has the option, but not the obligation, to exercise the contract, hence the name "option contract." Many options do expire without being exercised, simply because it would not be profitable for the option owner to employ this right.
Option Rights
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Each option grants one of two types of rights to the option owner, the right to buy or the right to sell. Options granting the right to buy are known as call options, while those offering the right to sell are put options. Along with the right to buy or sell is an associated price at which the security must be traded, referred to as the option's strike price.
These right types help to generally define an investor's outlook regarding the underlying security. Buying a call and selling a put are considered "bullish," while buying a put and selling a call are "bearish." The collective and compared positions of active or "open" options contracts are sometimes used to gain a sense of market sentiment in the underlying security. This indicator is known as the open interest.
Time Value
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An option that has expired may no longer be exercised, and without that possibility it no longer holds any value. Because of this, an option's premium naturally decreases as its expiration date approaches. This is known as the "time value" of an option's contract. Options with more distant expiration dates have greater potential for increases in value, and premiums tend to reflect this by being more expensive.
Intrinsic Value
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Another factor affecting an option's premium is its intrinsic value. Intrinsic value represents the difference between the option's strike price and the current market value of the underlying security. Options with a positive intrinsic value are referred to as "in-the-money," while options with negative intrinsic value are said to be "out-of-the-money." Premiums therefore tend to rise or fall in direct relation to an option's current intrinsic value.
Hedging
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Options are often described as high-risk investments, however, they may also be used as a hedge against risk. For example, imagine an investor who has shorted 100 shares of XYZ company stock. He fears the stock may rise in the near term, but does not want to cover his short position now. As a hedge against a potential loss he may decide to purchase a call option.
Should the stock increase in price, the value of the call option would rise even as the value of the short position falls. His cost for this insurance against an unfavorable move in the stock amounts to the premium price of the call option. He may exercise the call option to cover his short at a price lower than security's current market value, sell the option back at a profit and retain his short position, or simply permit the option to expire and potentially profit from his original short.
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