An option is the potential to participate in a future price change. So, if you own a call, you can participate in the uptrend of a stock without owning the stock. You have the option to participate.

In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option would be that profits from that event. For instance, a call value goes up as the stock (underlying) goes up. This is the key to understanding the relative value of options.

Let’s look at an example of a call option on International Business Machines Corp. (IBM) with a strike price of \$200 expiring in three months. IBM is currently trading at \$175. Remember, owning the call option gives you the right, but not the obligation, to purchase 100 shares of IBM at \$200 at any point in the next three months. If the price of IBM rises above \$200 at any point within three months, then the call option will become in-the-money.

The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminishes as we draw closer to expiry. This is why an option is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day. Since time is a component to the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.

Accordingly, the same option strike that expires in a year will cost more than the same strike for one month.

This wasting feature of options is a result of time decay. The same option will be worth less tomorrow than it is today if the price of the stock doesn’t move.

See below an excerpt from my Options for Beginners course where I introduce the concept of time decay:

Let’s go back to our IBM three-month call example. The most important factor that increases the value of your call is the price of IBM stock rising closer to \$200. The closer the price of the stock moves towards the strike, the more likely the call will expire in-the-money. Simply stated, as the price of the underlying asset rises, the price of the call option premium will also rise. Alternatively, as the price goes down – and the gap between the strike price and the underlying asset price widens – the option will lose value. Similarly, if the price of IBM stock stays at \$175, the \$190 strike call will be worth more than the \$200 strike call, because the chance of IBM rising to \$190 is greater than the chance of reaching \$200.

Volatility also increases the price of an option. This is because uncertainty pushes the odds of an outcome higher. If the volatility of the underlying asset increases, larger price swings increase the possibilities of substantial moves both up and down. Greater price swings will increase the chances of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Options trading and volatility are intrinsically linked to each other in this way.

With this in mind, let’s consider this hypothetical example. Let's say that on May 1, the stock price of Cory's Tequila Co. (CTQ) is \$67 and the premium (cost) is \$3.15 for a July 70 Call. Seeing only “July” with no date indicates that the expiration is the third Friday of July. The strike price is \$70. The total price of the call contract is \$3.15 x 100 = \$315. In reality, you’d need to consider commissions, but we'll ignore them for this example.

On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that's why you must multiply the contract premium (\$3.15) by 100 to get the total amount you’ll have to spend to buy the call (\$315). The strike price of \$70 means that the stock price must rise above \$70 before the call option has intrinsic value.  Furthermore, because the contract is \$3.15 per share, the break-even price at expiration would be \$73.15 (Strike price + premium).

Three weeks later, the stock price has risen to \$78. The call option contract has increased in value along with the stock price and is now worth \$8.25 x 100 = \$825. Subtract what you paid for the contract, and your profit is (\$8.25 - \$3.15) x 100 = \$510. The call has \$8.00 of intrinsic value. Remember that for calls, stock price minus strike = intrinsic value. \$78 - \$70 = \$8.00. The remaining \$0.25 is time value (more on this later).

In this scenario, you’ve almost doubled your money in just three weeks! You could sell your call option, which is called "closing your position," and take your profits – unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride.

By the expiration date, the price of CTQ drops down to \$62. Because this is less than our \$70 strike call option and there is no time left, the option contract expires worthless. We have no position in the stock and we have only lost the original premium we spent of \$315.

To recap, here is what happened to our option investment:

 Date May 1 May 21 Expiry Date Stock Price \$67 \$78 \$62 Option Price \$3.15 \$8.25 worthless Contract Value \$315 \$825 \$0 Paper Gain/Loss \$0 \$510 -\$315

So far, we've talked about the option holder having the right to buy or sell (exercise) the underlying stock. While this is technically true, a majority of options are never exercised. In our example, you could make money by exercising at \$70 and then selling the stock back in the market at \$78 for a profit of \$4.85 a share (\$8.00 stock gain minus \$3.15 premium). You could also keep the stock, knowing you were able to buy it at a discount to the present value. However, the majority of the time, holders choose to take their profits by trading out (closing out) their position. This means that option holders sell their options in the market, and writers buy their positions back to close. According to the CBOE , only about 10% of options are exercised, 60% are traded (closed) out, and 30% expire worthless.

Now is a good time to dig deeper into pricing options. In our example, the premium (price) of the option went from \$3.15 to \$8.25. These fluctuations can be explained by intrinsic value and extrinsic value, which is also known as time value. An option's premium is the combination of its intrinsic value and its time value. Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the amount above the strike price that the stock is trading. Time value represents the added value an investor has to pay for an option above the intrinsic value. This is the extrinsic value, or time value. So, the price of the option in our example can be thought of as the following:

A brief word on options pricing. The market assigns a value to an option based on the likely outcome relative to the underlying asset, as in the example above. But in order to put an absolute price on an option, a pricing model must be used. The most well-known model is the Black-Scholes-Merton model, which was derived in the 1970s, and for which the Nobel Prize in economics was awarded. Since then, other models have emerged, such as binomial and trinomial tree models, which are commonly used by professional options traders. In real life, options almost always trade at some level above their intrinsic value, because the probability of an event occurring is never absolutely zero, even if it is highly unlikely.

Options Basics: Types of Options
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