Basic Terms

• The price at which you can buy or sell shares via a stock option is called the strike price. The price you pay to buy an option is called the premium. You pay the premium to buy an option, or collect it if you sell an option. A call can be out-of-the-money, at-the-money or in-the-money if the underlying stock price is below, equal to or above the option strike price, respectively. A put has the reverse relationships with the price of the underlying stock. All options have an expiration date, which is usually the third Friday of each month -- options can have lifetimes ranging from one month to over a year.
  
  

Value Components

• The premium of an option flows from two sources: (1) the extent to which the option is in-the-money and (2) the time left until expiration. For example, suppose you purchase for $275 one call option on XYZ Corp. stock with a strike price of $85 a share and one month left until expiration. The current price of XYZ Corp. stock is $87 a share at time of option purchase. The call's money value per share is $87 minus $85, or $2. Since the option controls 100 shares, the money value is $200 for the in-the-money call. The additional $75 of premium is due to the uncertainty of stock prices until option expiration.
  
  

Buyer's Perspective

• As the option buyer, you can experience three outcomes. The first is for the option to expire out-of-the-money, worthless. The second is that you can sell your option any time before expiration for its current price. Lastly, you can exercise the option and purchase or sell the underlying shares at the strike price. The options money value derives from the fact that you can exercise and then sell the resulting shares. If you own a XYZ Corp. $85 call when the stock is selling for $90, you will collect at least $5 a share, or $500, by either selling the option or selling the underlying shares. Your profit will be at least $500 minus $275 -- your premium -- or $225.
  
  

Sellers Perspective

• As an option seller, you collect the initial premium (in our example, $275) and hope the option expires out-of-the-money. That's because an in-the-money option can be exercised against you, which means, in the case of a call, you are obligated to buy the shares and deliver them to the option buyer. At a share price of $90, you will spend $9,000 to acquire the shares but will only receive $8,500 (the strike value) for them, giving you a net loss of $275 minus $500, or $225. Had the option been a put, it would have expired out-of-the-money and your profit would equal your initial premium of $275.