Options are financial contracts that give you the right, but not the obligation, to buy or sell a specific security at a set price, called the strike price, for a predetermined period. The two primary types of options are calls and puts, but call options are the most commonly traded. The market price of a call option can be influenced by a number of factors, including the strike price.
The market value of a call option is divided into two parts -- its intrinsic value and its time value. Intrinsic value is based on whether or not the market price of the underlying security is trading above or below the call option's strike price. If the security's market price is at or below the option's strike price, the call option is said to be "out of the money" and it has no intrinsic value. If the security's market price is trading above the strike price, the option is "in the money." The intrinsic value of an in-the-money call option is equal to the difference between the security's market price and the option's strike price.
Most American-style options have expiration dates of one year or less. Once the option expires, it becomes worthless and ceases to exist. Since the market price of the security might increase before the option's expiration date, there is a certain amount of value to owning the call option, even if it is out of the money. The difference between the market price of a call option and its intrinsic value is called the option's time value.
Call options are purchased with a fixed strike price and expiration date. Regardless of what happens with the underlying security's market price, neither the call option's strike price nor expiration date will change. The market price of an in-the-money call option will increase in tandem with any rise in the market price of the underlying security. The price of an out-of-the-money call option might increase as the market price of the security approaches the strike price, but the amount of increase will be influenced by how much time remains before expiration.
The price of a call option is not based on the strike price of the underlying security but on the relationship between the option's strike price and the current market price of the security. There can be a number of different strike prices and expiration dates for call options on a single security. The market price for a call option with a lower strike price will be higher than the market price for a call option on the same security with the same expiration date but with a higher strike price.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.