Perhaps you have read about stock options and how they allow you to use leverage for big profits.
You might also be very wary of buying put and call options because you've heard stories of people losing a lot of money very quickly.
Well, you're smart to be wary because options to involve risk, but that doesn't mean that understanding options pricing is a bad idea.
Some investors see fit to put a small percentage of their investment funds into options, periodically, in an effort to enhance their overall portfolio.
Understanding concepts like "intrinsic value" and "time value" is a first step towards really "getting" options.
Before we look at what determines the price of stock options, let's quickly review options basics.
Let's take an example of one Yahoo April 16 call contract.
if you own this contract you have the right to buy 100 shares of Yahoo at $16 a share at any time before the end of the third week in April.
Options contracts always expire at the close on the third Friday of the "expiration month".
(In practice, options contracts are not used to buy stock before the expiration date, they are themselves simply bought and sold until expiration) I will illustrate options pricing with an example.
Let's say Yahoo is at $15.
50/share at the moment.
If I buy the "April 16s", at a price of 0.
55, let's say, the contract would cost me $55 because it covers 100 shares of stock.
For that $55 I may buy 100 shares of Yahoo stock at the $16 "strike price", regardless of the actual price of the stock between now and April.
Right now, it might appear that this "out of the money" contract has no value at all since I would never want to buy something at a price ($16) higher than the current ($15.
50) market value.
But the contract does have value: it has "time value".
Let's say that there are 2 1/2 months left before the contract expires.
The market understands that a lot can happen in that time, and for this reason assigns the contract in our example a value of 0.
55.
Now, what if one month later the price of Yahoo rises to $17.
50 a share and our option increases in value to, say, 1.
60.
At this point, since our contract gives us the right to buy 100 shares at $16, which is below the current price, we say that it is "in the money".
It has an "intrinsic value" of $1.
50, as the stock price is 1.
5 points higher than our contract's strike price.
The idea is that if we "exercised" our option to buy at this point, we know that we could immediately sell the shares for a profit of $1.
50 per share, or $150.
With 1 1/2 months left until exploration, naturally the contract has time value as well.
As the contract is priced at 1.
6, the time value is now.
10, which is simply the difference between the intrinsic value and the option price.
I have used this example to illustrate the two basic components in the price of a stock option: intrinsic value and time value.
I also touched on most of the basic terminology involved in stock options trading.
There is a lot more to learn, but probably the most vital thing to remember is that options are very risky investments, and that an option trade can result in the loss of your entire investment, even if you understand them very well!