When you buy a stock option, you gain control over the underlying stock for a fixed period of time, but you don't actually own the stock. Instead, you pay a premium for the right to purchase the stock for a set price, called the strike price, through the expiration date. How the price you pay for that option is determined depends on a number of factors.
A stock option's intrinsic value is equal to the profit you would gain by exercising the option and immediately selling the underlying stock, without regard to any transaction fees or commissions. A call option's intrinsic value is always either $0 or the amount by which the underlying stock price exceeds the option's strike price. A put option's intrinsic value is always either $0 or the amount by which the option's strike price exceeds the underlying stock price. For example, if XYZ stock is trading for $41 per share, an XYZ 35 call option would have an intrinsic value of $6 ($41 - $35). If XYZ stock was trading a $34, the XYZ 35 call option would have $0 intrinsic value. Stock options do not have a negative intrinsic value.
An option that has intrinsic value is said to be in-the-money, while an option with no intrinsic value is said to be out-of-the-money. The market price of all stock options is a combination of the option's intrinsic value and its time value. You can calculate an option's time value by subtracting the option's intrinsic value from its market price. Whatever is left is its time value. An option's time value fluctuates based on such factors as time remaining to expiration, volatility of the underlying stock, price difference between the option's strike price and the stock's market price and other factors.
Price movements of stock options tend to be less volatile than price movements of the underlying stock. The market price of an in-the-money stock option typically moves in tandem with movements in the market price of the underlying stock, while price movements for out-of-the-money options will be less pronounced. The time value of a stock option tends to erode as the option nears its expiration date.
Each stock option controls 100 shares of the underlying stock. A call option gives the owner the right, but not the obligation, to buy the stock for a set price, while a put option gives the holder the right, but not the obligation to sell the stock for a set price. Options trading strategies can be either quite conservative, such as selling covered call option, or wildly speculative, such as selling uncovered call options. Whether the option strategy is conservative or speculative, all option transactions involve some level of risk.
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.