Before we go any farther into trading stocks and options we should get a good understanding as to what options are. In the world of finance, an option is a legal contract which gives the buyer the right, but not the obligation, to buy or sell the underlying asset at a specified strike price on AND before a specified date. This is the American style option. There are also European style, but we are not going to cover them here.
The strike price of the option is set at the time of sale on the underlying stock or commodity on the day an option is bought. The seller of the option has a corresponding obligation to fulfill the transaction whether that is to sell or buy the asset.
If the buyer of the option exercises the option the seller must deliver the underlying asset. A call option conveys to the owner the right to buy at a specific price. A Put option the right of the owner to sell at a specific price.
The seller may grant an option to a buyer as part of another transaction, such as a share issue or as part of an employee incentive scheme, otherwise a buyer would pay a premium to the seller for the option. A call option would normally be exercised only when the strike price is below the market value of the underlying asset, while a put option would normally be exercised only when the strike price is above the market value.
When an option is exercised, the cost to the buyer of the asset acquired is the strike price plus the premium, if any. When the option expiration date passes without the option being exercised, then the option expires and the buyer would forfeit the premium to the seller. In any case, the premium is income to the seller, and normally a capital loss to the buyer.
The market price of the option usually closely follows that of the underlying stock, being the difference between the market price of the stock and the strike price of the option. The amount of change is referred to as the Delta. It is influenced by many factors, including the market volatility, how close the underlying asset is the the strike price, time till expiration and market forces, like how much demand there are for puts or calls.
When the market is trending up then calls tend to become inflated in price due to demand. In bear markets or when there is a lot of market volatility, prices on put options tend to become inflated.
The ownership of an option does not generally entitle the holder to any rights associated with the underlying asset, such as voting rights or any income from the underlying asset, such as a dividend. Options tend to be a popular vehicle for speculating as they have a great amount of leverage.
Leverage allows a trader to make a great deal more on his investment than the outlay. In other words a trader could control $100,000 worth of stock for $100. Of course the odds are the option will expire worthless. Time is the option buyers enemy and the option sellers friend.