Learning To Invest Summary Options derive their value from the underlying security. price.

The price of options are composed of intrinsic and premium value.

Volatility, time, and the distance from the strike price to the stock price determine the premium value.
Stock Options
Options are derivative securities, implying that their value is based upon another security, either a stock, index, or future. Two types of options exist, calls and puts. When one buys a call, it entitles the owner to purchase the underlying security at a specified price, the strike, for a certain amount of time. For example, an IBM Nov. 50 call gives the owner the right to buy IBM stock at $50 a share until the call expires in November. Similarly, a put entitles the owner to sell the underlying security at the strike price until the put expires. Options expire on the third Friday of each month. Additionally, you can either buy or sell options. Thus, selling a call obliges the writer to sell the stock at the strike, and selling a put option obliges the seller to buy the stock at the strike if the option is exercised. Stock options usually come in one hundred share increments. Employing combinations of puts and calls, we can build all of the strategies presented in our strategy guide.

Now that you have the definition of an option under control, lets examine the pricing of options. Two parts compose the price of an option, intrinsic value and premium. Intrinsic value equals the amount by which the option is in the money (an in the money call option occurs when the stock price is above the strike, and similarly for a put when the stock price is below the strike). For example, with the stock price at 54, a call contrat, which has a strike of 50 is four points in the money, and thus has an intrinsic value of four points. Intrinsic value also represents the value that the contract would have if the option expired today. In the chart below, the straight pink line, rising from zero at 50, depicts the intrinsic value for our example. The premium, the second component of the price, represents the fee you pay (or receive when selling an option) for the right to buy or sell the underlying security at a certain price during a specified period. Several factors determine the premium of an option. Obviously, the time remaining in the contract is the primary factor. As you increase the time remaining, you also increase the probability that the option will become profitable, thereby raising the premium. Also, the underlying volatility of the security plays a vital role. A more volatile security has a greater likelihood to rise or fall quickly and make an option valuable. Thus, you must compensate the seller, or writer, for taking on the additional volatility with higher premiums. Finally, the strike price relative to the stock price is relevant to the premium value. The premium value peaks when the strike price equals the security price (at the money), and decreases as the security price moves away from the strike price. Therefore, a stock option with a strike of 50 on an underlying stock with a price of 60 will be worth about 10. In this case the price is almost all intrinsic value. Take another look at the above chart. The shaded region represents the premium, whereas the blue vertical line depicts the maximum premium height, which coincides with an at the money option.

Some notes before we continue:


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