How To Trade Options

When trading the options markets, it is key for investors to understand many of the terms and nuances of these derivative financial instruments.  One of the components that is pertinent to successful trading is the concept that an option expires at a specific data and time.  Unlike a stock, that can be held for years, an options will expire either in the money or out of the money on a certain data.

Option traders have a few ways to monetize gains when trading options.  If an option is in the money, where the current underlying markets is more than the strike of a call option, the investor can sell the option, or exercise the options.

The term exercise refers to the process where the buyer notifies the seller that he will be buying or selling the underlying asset at the strike price. The expiration date is the date when the option is no longer valid or active.

For example, if an investors purchased a IBM call option at $100 dollars, and the price moved to $110 prior to the expiration date, the investors who owns the call option on IBM could exercise the option and instead receive shares at the purchase price of $100.

The cost of purchasing an option is called the premium.  The total price of an option (premium) consists of two components.  Those two components are intrinsic value and extrinsic value (also called time value). The intrinsic value of an option is simply the amount by which it is in-the-money. Any additional value in the option is because time remains on the contract and is called the extrinsic value (or time value).  In the example of IBM, the intrinsic value of the option is $10 dollars, ($110 – $100), the extrinsic value is any amount more than this amount.

Extrinsic value is defined as the option’s price less its intrinsic value. It can be thought of as any excess value in the option not explained by intrinsic value. In the case of out-of-the-money options, the option’s entire price consists only of extrinsic value.

The term time decay is defined as the rate by which an options extrinsic value decays over the life of the option. Therefore, time decay and extrinsic value decay are two ways of expressing the same concept.