Stock options are simply contracts that give the owner the right to buy (call option) or sell (a put option) a stock at a specific price at some time in the future. That price is called the strike price. The period of time could be as short as a day or as long as a couple years, depending on the option. The interesting thing about buying an option is you have the right, but not the obligation, to buy or sell that stock before it expires. And for every options buyer there is a seller, who has to take the opposite side of the trade. Unlike the buyer, the seller has the obligation to sell or buy that stock if the buyer exercises his option.
Remember, there are only two types of options: calls and puts. However, options traders often combine these strategies to create dozens of different strategies.
Options are quoted with a bid (what someone is willing to pay) and ask (what someone is willing to sell for) the option. Options may be bought, or sold, using either market orders or limit orders. Since options typically have lower volumes and have wider bid-ask spreads, it's often a good idea to use limit orders when placing a trade to get an execution price in-line with what you are willing to pay.
A single equity option contract represents an option on 100 shares of the underlying stock. Quotes for equity options are multiplied times 100 to yield a total cost for the position.
Strike prices are the stated price per share for which the underlying security may be bought or sold. Equity option strike prices are listed in increments of 1, 2.5, 5 or 10 points, depending on their price level.
If a stock option is purchased it is considered to be a debit trade (premium paid). If a stock option is sold, it is considered to be a credit trade (premium collected).
Understanding an Option's Profit Potential
One of the most useful things you'll learn in trading options is how to read a "profit curve", which visually shows the profit potential of your trade.
When you purchase an option, you pay the "option premium" for the right buy that stock. So unless the stock moves up by expiration day, you're simply out that money.
If the price of the stock moves up past the "strike price", then you start making that money back. And if it moves up enough, you've turned a profit! As you can see on the chart, the profit potential of a call option is in theory limitless. As long as the underlying stock price continues to increase, the value of your option will continue to increase. And since a single option contract controls 100 shares of stock, the value of your option moves up 100 times as fast as a single share of that stock.
If the price of the option goes down, you're simply out the option premium. You can never lose more than the premium paid (plus any commissions you paid to the broker).
When you buy an option, the profit and loss curve looks a bit different than it will on option expiration day. Option expiration day is on the third Thursday or each month. That's because the value includes the option premium. In other words, when you buy an option you could possibly turn around and sell it and recoup most or all the premium you just paid.
The premium option price is determined by a variety of factors:
Intrinsic value of the stock option - is just the value given to that option at expiration.
Time value of the stock option - is the more time you have before an option's expiration date, the higher the chance that it could hit or exceed the option's strike price. So as you get closer to expiration day, the time value decays away. A good metaphor to remember this is similar to an ice cube slowly getting closer to a fire. It's "size" or "value" is slowly is getting smaller as you get closer to the expiration date or "fire".
Volatility of the underlying stock - is ff a stock has been jumping all over the place recently, then the chance that it will make a strong movement in your favor is generally higher. If you bought an option whose volatility was fairly low and all of a sudden the underlying stock starts bouncing around more, then your option is usually going to be worth more prior to expiration.
Difference between the underlying stock price and the option strike price - the closer the stock price is to the strike price, the higher chance the option will expire "in the money".