Options Basic Terminologies

There are two basic types of options. A call option gives the holder the right to buy the underlying asset by a certain date for a certain price. A put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The price in the contract is known as the exercise price or strike price; the date in the contract is known as the expiration date or maturity date. American options can be exercised at any time up to the expiration date. European options can be exercised only on the expiration date itself. Most of the options that are traded on exchanges are American. In the exchange-traded equity options market, one contract is usually an agreement to buy or sell 100 shares. It should be emphasized that an option gives the holder the right to do something. The holder is not obligated to exercise this right.

Exercise
To exercise an option is to implement the right under which the holder of an option is entitled to buy (in the case of a call) or sell (in the case of a put) the underlying security.

In/at/out of money
Options can often be described to be in the money, at the money or out of the money.  These terms refers to the relative position of the option strike price to its underlying stock price.

In-the-money
Any option that has intrinsic value is said to be in the money. A call option is in-the-money if the underlying stock is higher than the striking price of the call. A put option is in-the-money if the stock price is below the striking price. At expiration, in the money options will be exercised as  they have intrinsic value.

At-the-money
An option is at-the-money if the strike price of the option is equal to that of its underlying stock price. At expiration, all at the money option will expire worthless as there is no point of exercising the option when you can buy or sell the stock at market price that is equal to its strike price.

Out-of-the-money
A call option is out-of-the-money if the strike price is greater than the market price of the underlying security. A put option is out-of-the-money if the strike price is less than the market price of the underlying security. At expiration, out of money options will not be exercised and therefore worthless.

Options Pricing
The price of an option contract is called the premium of the option. The premium is primarily affected by the difference between the stock price and the strike price of the option, the time remaining for the option to be exercised, and the volatility of the underlying stock.  The total value of an option consists of intrinsic value, which is simply how far in the money an option is, and time value, which is the difference between the option premium and its intrinsic value. Understandably, time value approaches zero as the expiration date nears.

Strategies

Long Call
When a trader believes that a stock price will increase in the near future, the trader may purchase call options rather than buying the stock. For example, consider the situation of a trader who buys a call option with a strike price of $125 to purchase 100 Apple shares. Suppose that the current Apple stock price is $118, the expiration date of the option is in four month, and the price of an option to purchase one share is $8. Therefore the initial investment is $800 as there are 100 shares in one contract. If by the expiration date the stock price is less than $125, the trader will clearly choose not to exercise the call option. (There is no point in buying, for $125, a share that has a market value of less than $125) In these circumstances, the investor loses the whole of the initial investment of $800. If the stock price is above $125 on the expiration date, the option will be exercised. Suppose, for example, that the stock price is $140. By exercising the option, the investor is able to buy 100 shares for $125 per share. If the shares are sold immediately, the trader makes a gain of $15 per share or $1,500. When the initial cost of the option $800 is taken into account, the net profit to the investor is $700.

Put Options
Whereas the purchaser of a call option is hoping that the stock price will increase, the purchaser of a put option is hoping that it will decrease. Consider a trader who buys a put option to sell 100 shares of Apple with a strike price of $115. Suppose that the current stock price is $118, the expiration date of the option is in two month, and the price of an option to sell one share is $4. The initial investment is $400. Suppose by expiration date the Apple stock price is $100. The trader can buy 100 shares for $100 per share and, under the terms of the put option, sell the same shares for $115 to realize a gain of $15 per share, or $1,500 for the contract. When the $400 initial cost of the option is taken into account, the investor’s net profit is $1,100. However if the final stock price is above $115, the put option expires worthless and the trader loses $400.

Writing Options
When selling or writing an option, the option writer is obligated to sell the underlying security at the strike price within a specific time when writing a call option, or purchase the underlying security at the strike price within a specific time when writing a put option. In return, the option writing receives a premium from the option buyer.

Writing Calls
When a trader believes a stock will fall or will not raise the trader can write call options against that stock. For example, suppose a trader believes that the short term resistance on Google stocks is $500 and that it is very unlike for Google stocks to surpass the $500 mark. When the stock is trading around $490, the trader writes a $500 call option with premium of $8 per share with expiration date of 1 month. The trader will therefore receive a credit of $800 upon entering the position. (100 shares per option contract x $8 per share) If by the expiration date the stock price is less than the strike price of $500, the trader will keep the entire premium as the options expires worthless. However if the stock price rise above $500, the trader’s profit will start to disappear. For example, if the stock closed at $510 on expiration date, the option writer will have to sell the stock to the option holder for $500 per share. Since the option writer does not hold any google stock, the writer would have to buy the shares at market price at $510 per share and then sell them to the holder for $500. Resulting in a ($500-$510)x100 =  ($1000) loss. However upon entering the position the trader received $800 of credit from the premium, therefore the net loss for the trader would be $200 dollars. (in actuality the trader does not have to go buy the stock and resell them to the option holder physically, the broker will take care of the exercise of the option, the trader will simply have to pay the difference between the option strike price and the price of the option, in this case $1000.)
It should be noted that writing naked calls (selling call options while not holding the underlying stock) is one of the riskiest strategies of all as the option writer will be exposed to unlimited risk as the price of a stock can theoretically rise infinitely.

Writing Puts
When a trader believes that a stock will rise or will not decrease the trader can write put options against that stock. Consider a situation where a trader expects the price of Apple stock to be fairly positive and stable in the next two month as the current price of Apple is $120. The trader decides to short a put option that is expiring in two month with strike price of $100 and collect $400 from the option premium. If by expiration Apple stock price is above $100, the trader will keep all of the $400 as the put option expires worthless. But if the stock price is below $100, the trader will be obligated to buy the Apple shares from the option holder for $100. For example, if the price of the stock is $95 at expiration, the option writer will have to buy the stock for $100 a share, and if the writer decides to sell the shares immediately, he would have to sell them at market price of $95 therefore resulting in a $500 loss. But because he received $400 in option premium for writing options, his net loss would be $100.

Advantages and disadvantages of long and shorting options
There are both advantages and disadvantages when longing or shorting options. When holding just a long position on a call option, the trader has the advantage of using leverage to achieve significant returns as oppose to buying the underlying stock. However, because options have expiration date, an options’ extrinsic value or time value diminishes as it approaches expiration. Therefore while longing a position holds the possibility of great profits, but the probabilities of achieving those profits are slim as profitability involves the stock to move in the right direction by certain amount of time. It should be noted that statistically, majority of the option buyers will suffer a loss from their position.

On the other hand shorting options gives the seller the advantage that time is work for the seller. This is also due to the fact that as the option approaches expiration its extrinsic value decreases. However if the stock does move against the seller, the seller could suffer heavy losses even without limitation in the case of selling a naked calls as the price of a stock could theoretically rise to infinity.
Spreads

To take advantage of both long and shorting options, a trade can enter multiple options positions simultaneously such as longing and shorting options of the same stock with different strike prices. These combined positions are called spreads.

Credit Spreads:
A credit spread involves the simultaneous purchase and sale of puts (or calls) that expire at the same time but have different strike prices. Puts are used if you are bullish on the underlying stock or index, while calls are used for a bearish outlook. For out-of-the-money credit spreads, the strike price of the sold (or written) option is closer to the underlying stock's market price than the purchased option and therefore has a higher premium. This results in a net credit. The goal of a credit spread position is to retain this net credit by having both options in the spread expire worthless.

Debit Spread
A debit spread also involves the simultaneous purchase and sale of puts (or calls) that expire at the same time but have different strike prices. But unlike the credit spread, the purchased option will cost more than the sold option, therefore resulting in a net credit.

Iron Condor
In the Iron Condor, an investor will combine a Bear-Call Credit Spread and a Bull-Put Credit Spread on the same underlying security. By doing this, an investor will potentially be able to double the credit obtained over a single spread position. Since there are two spreads involved in the strategy (four options), there is an upper break even and a lower break even. A profit is made if the stock remains above the lower breakeven point or below the upper breakeven point.