An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted upon. It has an expiry date. When an option expires, it no longer has value and no longer exists.
Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices – whether to buy or sell and whether to choose a call or a put – based on what you want to achieve as an options investor.
What a particular options contract is worth to a buyer or seller is measured by how likely it is to meet their expectations. In the language of options, that is determined by whether or not the option is, or is likely to be, in-the-money or out-of-the-money at expiry.
A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price.
A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it.
If an option is not in-the-money at expiry, the option is assumed to be worthless.
Several factors, including supply and demand in the market where the option is traded, affect the price of an option, as is the case with an individual stock. What’s happening in the overall investment markets and the economy at large are two of the broad influences. The identity of the underlying instrument, how it traditionally behaves, and what it is doing at the moment are more specific ones. Its volatility is also an important factor, as investors attempt to gauge how likely it is that an option will move in-the-money.