General Concepts:   

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1. Strike price: Where the owner of the option has the right to buy, or sell the underlying security at a fixed price. Conversely, where the seller of the option is obligated to buy, or sell the underlying security at a fixed price

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2. Expiration date: Date on which the option contract expires

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3. Premium: Amount paid to buy an option and the amount received to sell an option

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4. Time: The further out the contact expires the greater the premium one will have to pay in order to secure a given strike price. The greater the volatility, the higher the premium

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5. Intrinsic value: The value of the underlying security on the open market, if the price moves above the strike price, the option will increase in lock-step

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6. Exercise: When the owner of the option contract converts their right to buy or sell shares to the actual purchase or sale of those shares 

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Technically, an option is a contract which gives the buyer (paying out a premium) of the contract the right, but not the obligation, to buy or sell the stock of interest at a specified price on or before a specified date. The seller (receiving a premium) of the option has the obligation to buy or sell the stock of interest if the buyer exercises the option contract. An option that gives the buyer the right to buy the stock at a specific price is referred to as a call; an option that gives the right of the owner to sell the security at a specific price is referred to as a put.    

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Basic Option Types - Calls and Puts:

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Call Options:

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A call option is a contract between a buyer and a seller to purchase a specific stock at a specific price by an agreed expiration date. The buyer of the call option has the right but not the obligation to buy the stock. A call option can be purchased to have the right to buy the stock at a later date for an agreed upon price while paying a premium for the right to buy shares at or before an agreed upon date. Here the option buyer believes the shares will increase in value in the future and pays a premium to have the right to buy the shares in the future. If shares appreciate beyond the price that was agreed upon (strike price) then the option buyer can exercise (buy the shares) the option.         

 

Call Example:

 

Current price of XYZ is $100 per share. Purchase of a call option to have the right to buy the shares at $105 a month from now. The buyer believes the stock will rise past $105 thus be able to buy the shares for $105 (less the premium paid for the option contract) when shares may be worth much more than $105 a month from now. Then the owner of the option would exercise the $105 option and assume the shares at a purchase price of $105 when the shares may be worth much more on the open market.

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Put Options:

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A put option is a contract between a buyer and a seller to sell a specific stock at a specific price by an agreed expiration date. The buyer of the put option has the right but not the obligation to sell the stock. A put option can be purchased to have the right to sell the stock at a later date for an agreed upon price while paying a premium for the right to sell shares at or before an agreed upon date. Here the option buyer believes the shares will decrease in value in the future and pays a premium to have the right to sell the shares in the future. If shares fall beyond the price that was agreed upon (strike price) then the option buyer can exercise (sell the shares) the option.         

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Put Example:

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Current price of XYZ is $100 per share. Purchase of a put option to have the right to sell the shares at $95 a month from now. The buyer believes the stock will fall below $95 thus be able to sell the shares for $95 (less the premium paid for the option contract) when shares may be worth much less than $95 a month from now and avoid further downside. Then the owner of the option would exercise the $95 strike option and relinquish the shares at a sale price of $95 when the shares may be worth much less on the open market.   

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