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What is an Option?

An option is a contract to buy or sell a specific financial product officially known as the option's underlying  instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund  (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at  which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no  longer has value and no longer exists.

Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices - whether  to buy or sell and whether to choose a call or a put - based on what you want to achieve as an options investor. 


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 to open a short option position obligates  you, the writer, to fulfill your side of the contract if the holder wishes to exercise. When you sell a call as an opening  transaction, you're obligated to sell the underlying interest at the strike price, if you're assigned. When you sell a put  as an opening transaction, you're obligated to buy the underlying interest, if assigned. As a writer, you have no  control over whether or not a contract is exercised, and you need to recognize that exercise is always possible at  any time until the expiration date. But 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.


At a Premium
When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you  receive. The premium isn't fixed and changes constantly - so the premium you pay today is likely to be higher or  lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between  what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there's  agreement becomes the price for that transaction, and then the process begins again.

If you buy options, you start out with what's known as a net debit. That means you've spent money you might never  recover if you don't sell your option at a profit or exercise it. And if you do make money on a transaction, you must  subtract the cost of the premium from any income you realize to find your net profit.

As a seller, on the other hand, you begin with a net credit because you collect the premium. If the option is never  exercised, you keep the money. If the option is exercised, you still get to keep the premium, but are obligated to  buy or sell the underlying stock if you're assigned.


The Value of Options
What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their  expectations. In the language of options, that's determined by whether or not the option is, or is likely to be,  in-the-money or out-of-the-money at expiration. A call option is in-the-money if the current market value of the  underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise  price. A put option is in-the-money if the current market value of the underlying stock is below the exercise 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.

An option's premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the  option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the premium  is. The longer the amount of time for market conditions to work to your benefit, the greater the time value. 


Options Prices 
Several factors, including supply and demand in the market where the option is traded, affect the price of an option,  as is the case with an individual stock. What's happening in the overall investment markets and the economy at  large are two of the broad influences. The identity of the underlying instrument, how it traditionally behaves, and  what it is doing at the moment are more specific ones. Its volatility is also an important factor, as investors attempt  to gauge how likely it is that an option will move in-the-money.