- Call options are the right to buy the underlying stock at a specific price for a set period of time. Put options are the right to sell the stock at a specific price. The price of the underlying stock at which an option can be exercised is called the strike price. If the underlying stock is above the strike price for calls or below the strike price for puts, the option is in-the-money or ITM. Options can also be out-of-the-money, OTM, or at-the-money, ATM. Options are listed in the form of AAPL Oct 175 Call. This option would be a call for Apple stock with a strike price of $175 that expires in October. The expiration date is the Saturday following the third Friday of the expiration month. One option contract is for 100 shares of the underlying stock.
- Investors buy options when they believe the underlying stock will move significantly up or down in price. Say Apple stock is currently trading for $165, and an investor believes the price will move to $200 in a few months. The call option with a $175 strike price and an expiration in two months costs $5.50. The investor buys one AAPL 175 Call contract for $550 plus commissions. She is correct in her forecast about Apple, and the stock is trading for $200 just before expiration. Her option is $25 in-the-money, and she can sell her contract for $2,500 less commissions making a profit of almost $2,000. Put options can be bought if you believe a stock will go down in price.
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The cost of an option contract will consist of a time value premium and the amount the option is in-the-money. OTM and ATM option prices are entirely time value. The time value is a function of the volatility of the underlying stock price and the amount of time until expiration. Time value erodes as you get closer to expiration. Options that reach the expiration date out-of-the-money expire worthless. The amount invested to buy an option is a 100 percent loss if it expires OTM. Buying out-of-the-money options is considered to be a riskier strategy than purchasing contracts already in-the-money. ITM options can also expire worthless if the stock price falls below the strike price by the expiration date.
If an option contract is in-the-money and not sold before expiration, it will be automatically exercised and the stock will be bought for the investor's account at the strike price. If an option owner does not want to own the stock, he must sell the contract before markets close on the Friday before expiration.
