Options

An option is a contract between two parties.  The first, the holder, is given the opportunity (but not the obligation) to purchase a stock by a given date at an agreed upon price.  The second party, the writer, is obligated to sell the stock at the contracted price if the holder chooses to follow through with his ‘option.’  In order to secure such a deal, the holder must pay a premium fee.  The option format as described above is called a call option.  If the process is reversed so that the holder is selling stock and the writer is buying, it is called a put option.  Stocks, commodities, bonds, currency, and indices can all be executed as options.  They are most commonly traded in futures and option markets such as the American Stock Exchange and the Chicago Board Options Exchange.  To make options more liquid, the Options Clearing Corporation was founded in 1973 allowing buyers and sellers of options to act independently of each other in a more centralized location.  There is a small OTC market for options, but it is very obscure.
               
There is a degree of risk associated with options, both for the holder and the writer.  The writer, obviously, has much more to lose.  If the price of the stock being optioned rises dramatically over the given time period, the holder is getting a severe discount on shares that he or she could turn around and make a large immediate profit on, entailing a loss for the writer.  The holder’s only risk is the loss of his premium.  This happens if the stock under contract takes an unfavorable turn and the option is not executed.  The risk is set in contract prior to the trade being followed through with, drastically reducing the risk on the part of the holder.  The writer’s risk, however, is unlimited.
               
There are two ways of determining an option’s value.  The first is the intrinsic value.  This is what profits would be earned if the holder executed the option, then turned around and reversed it in the stock market.  For instance, if one enacted a call option for a share of stock at $37, and then sold the same stock for $40 on the market, the intrinsic value would be $3. 
               
The second way of determining value is called time value.  This is the difference between the premium price and the intrinsic value when discussing ‘in-the-money’ options, or options that would be profitable if redeemed at a given moment.  If the option is ‘out-of-the-money,’ it has only time value.  The longer the amount of time until expiration, the higher the premium will be, thus increasing the time value of the option.  In other words, the longer the time period before the option expires, the more time value it will have since there is a higher chance of the market changing.

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