Options Trading Tutorial

Call Option

When you buy a call option, it gives you the right to buy a given asset at a fixed price (known as the strike price) anytime before a specified expiration date. The option writer (the person who created the option which you purchased), has the legal obligation to sell the asset to you at the strike price, if you exercise the option before the expiration date.

Put Option

A put option is just the opposite. When you buy a put option, it gives you the right to sell a given asset at the strike price anytime before the expiration date. The option writer has the legal obligation to buy the asset from you at the strike price if you exercise the option before it expires.
Underlying
The asset is usually referred to as the Underlying (underlying asset). Options are available for the following types of underlyings:

Futures (Commodities, Indexes, Currencies). Gold, silver, soybeans, wheat, crude oil, treasury bonds, eurodollars, foreign currencies, S&P 500 index, and many others.

Basics of Option

If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer during its term or to let it expire worthless.

The situation is different if you write, or "sell to open", an option. Selling to open a short option position obligates you, the writer, to fulfill your side of the contract if the holder wishes to exercise. When you sell a call as an opening transaction, you're obligated to sell the underlying interest at the strike price, if you're assigned. When you sell a put as an opening transaction, you're obligated to buy the underlying interest, if assigned. As a writer, you have no control over whether or not a contract is exercised, and you need to recognize that exercise is always possible at any time until the expiration date. But just as the buyer can sell an option back into the market rather than exercising it, as a writer you can purchase an offsetting contract, provided you have not been assigned, and end your obligation to meet the terms of the contract. When offsetting a short option position, you would enter a "buy to close" transaction.

What is Premium

When you buy an option, the purchase price is called the premium. If you sell, the premium is the amount you receive. The premium isn't fixed and changes constantly - so the premium you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there's agreement becomes the price for that transaction, and then the process begins again.

Option Pricing

Mathematical pricing models are used to calculate the theoretical price (fair value) of any option. An option's theoretical price depends upon the following factors. The most important factors are highlighted.

• type of option (call or put)
• strike price of the option
  
• current market price of the underlying
  
• statistical volatility of the underlying
  
• days remaining until the option expires
  
• the current risk free interest rate (90 day treasury bill rate)
  
• declared dividend amount per share (for stocks only)
  
• days until the ex-dividend date (for stocks only)

When an option's actual price differs from the theoretical price by any significant amount, traders try to take advantage of this situation, forcing the prices back in line, especially as the expiration date approaches.