How do options work?
Well, when you buy an option what you are actually doing is paying for a right. This right gives you the power to buy or sell a stock at a given price. There are two types of options. 1. A call option gives the owner the right to buy a given stock at a given strike price on or before a given date. For example if you pay $2 for the $50 December call on stock XYZ you have the right to buy stock XYZ at $50 on or before the 3rd Friday of December. This is true no matter where XYZ is trading at. If stock XYZ is trading at $60 by the 3rd Friday of the month you can buy it at $50 and sell it at $60 making $10. And you paid $2 for this right. That is the power of a call option. 2. A put option is just the opposite. While a call lets you make money when a stock goes up a put lets you make money when a stock goes down. It does this by giving the owner of the option the right to sell a stock at a given strike price by a given day. If you bought the December $50 put for stock XYZ for $3 you could buy XYZ on or before the 3rd Friday of December. Even if the stock drops down to $10 we can buy it at $10 and sell it at $50. Options are priced in 2 ways. The first way is called intrinsic value. This is the difference between the stock’s price and the options strike price. For example say a stock option with a strike price of $65 is trading a $4. The stock’s price is $68. Therefore the intrinsic value of the option is $68-$65 or $3. The remaining $1 is called time value . This is the value of the time before expiration. Options that are farther away from expiration will have more time value. Options closer to expiration will have less time value. As an option approaches expiration time value shrinks. That is what makes options riskier then stocks. In some cases the stock has to go up enough to cover the time value of the option for you to make money. Many traders love to trade options because of their high risk high reward potential. Others will combine different options and strike prices to make less risky spreads. Either way options can be a valuable part of your portfolio if you use them right.
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