Before any person is considering investing in Options, he or she has to know what they are, and how they work. First of all, one should know that an Option is a contract, which gives the owner the right to buy or sell shares of stock ( or an asset) at anytime before or on the expiration date of the option. Just like with equities, an investor may also decide if he or she wishes to take a short or long position on the asset depending on how they wish to play the trade. A call option is a contract which allows the owner to buy 100 shares of stock, or take a long position on it before or after the expiration date, whereas a put option is a contract which allows the owner to sell 100 shares of stock, or take a short position on it, before or after the expiration date.

Similar to the stocks in consideration, Options are likewise traded in the same fashion, and thus each one has its own bidding price and expiration. A certain option may only be executed or as traders more commonly say, exercised anytime before its expiration date. This is what makes options trading a risky business. Of course, when buying an option, it is said that your loss is limited to the premium of the option, which is the bidding price of the option. To understand this better, it is imperative to know what determines the bidding price.

The bidding price depends on several factors, namely the current market price, the expiration time, and the volatility of the underlying stock. The current market price determines whether an Option has intrinsic value or not. An Option is said to have intrinsic value (or in-the-money) when the current market price promises a profit in trade. A call option is said to have intrinsic value if the exercise price of the contract is lower than the current market price. Why? With the right to purchase shares at lower prices, investors get to enjoy bigger savings. Similarly, a put option is said to have intrinsic value if the exercise price of the contract is higher than the current market price. Why? With the right to sell shares at higher prices, investors enjoy additional profit. A secondary part of the option premium is the time premium. The time premium is dependent on the time before the contract expires.

A longer time would represent more time to monitor the behavior and movement of assets, therefore allowing investors to modify their trade strategies accordingly, which is why the further out the expiration date, the bigger the premium. The last factor is the volatility of options. Volatility, in this context, refers to the impression given by the behavior of the underlying asset. An asset, for example, with a consistent trade record is considered to be of low volatility, and is therefore predictable. Such options would have a low premium. On the contrary, if the underlying stock associated with an option were susceptible to violent price fluctuations, also called beta, it is said to be of high volatility, and rewarded with a higher premium.