Calls and Puts
Options come in two varieties, calls and puts, and you can buy or sell either type.
A call option gives the holder the right to buy a certain quantity of an underlying instrument from the writer of the option, at a specified price (the strike price), anytime prior the option expiration date. The seller (writer) of the call option has the obligation to sell the underlying instrument.
A put option gives the holder the right to sell a certain quantity of an underlying instrument to the writer of the option, at a specified price (strike price) anytime prior the option expiration date. The seller (writer) of the call option has the obligation to buy the underlying instrument.
Buying and Selling
If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless.
The situation is different if you write, or "sell to open", an option. Selling a contract obligates you, as the writer, to fulfill your side of the contract if the holder wishes to exercise. When you sell a call, you're obligated to sell the underlying interest at the strike price, if you're assigned. When you sell a put, you're obligated to buy the underlying interest, if assigned.
Just as the buyer can sell an option back into the market rather than exercising it, as a writer you can purchase an offsetting contract, provided you have not been assigned, and end your obligation to meet the terms of the contract. When offsetting a short option position, you would enter a "buy to close" transaction.
Option Price (Premium)
An option's price is called the "premium." When buying an option, you pay a premium to the seller. The premium isn't fixed and changes constantly. The premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow.
The potential loss for the holder of an option is limited to the initial premium paid for the contract. The writer on the other hand has unlimited potential loss that is somewhat offset by the initial premium received for the contract.
What a particular options contract is worth to a buyer or seller is determined by its “value”, which has two main components: an intrinsic value and a time value.
Intrinsic Value
Intrinsic value is “in-the-money” value, which represents the difference between the current price of the underlying instrument and the option’s strike price. Only “in-the-money” options have intrinsic value.
A call option is in-the-money if the current market value of the underlying instrument is above the strike price of the option, and out-of-the-money if the instrument is below the strike price.
A put option is in-the-money if the current market value of the underlying instrument is below the strike price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option is assumed to be worthless.
Time Value
Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor's benefit, the greater the time value.
Factors Influencing Options Premium
The factors having the greatest effect on option premiums are:
A change in price of the underlying security
Strike price
Time until expiration
Volatility of the underlying security
Dividends/Risk-free interest rate
Benefits of Option
Investors can use put and call option contracts to take a position in a market using limited capital. The initial investment would be limited to the price of the premium.
Investors can also use put and call option contracts to actively hedge against market risk. A put may be purchased as insurance to protect a stock holding against an unfavorable market move while the investor still maintains stock ownership. A call option on an individual stock issue may be sold, providing a limited degree of downside protection in exchange for limited upside potential.