What it is:
How it works (Example):
Options are derivative instruments, meaning that their prices are derived from the price of another security. More specifically, options prices are derived from the price of an underlying . For example, let's say you purchase a on of Intel (INTC) with an exercise of $40 and an date of April 16th. This option would give you the right to purchase 100 shares of Intel at a price of $40 on April 16th (the right to do this, of course, only be valuable if Intel is trading above $40 per share at that point.) As a quick example of how the exercise price determines whether a derivative such as a call option makes , let's say IBM is trading at $100 per share. Now let's say an investor purchases one call option contract on IBM at a price of $2 per contract. Note: Because each options contract represents an interest in 100 underlying shares of , the actual cost of this option be $200 (100 shares x $2 = $200).
Why it Matters:
The exercisederivative is going to make . Here's what happen to the value of this under a variety of different scenarios:of a largely determines whether the investor in that
Remember: The strike price gives the buyer the right to purchase of IBM at $100 per share. In this scenario, the buyer could purchase those shares at $100, then immediately sell those same shares in the for $105. Because the strike price is below the , this option is “ .” Because the investor purchased this option for $200, the to the buyer from this trade will be $300.
When the option expires, IBM is trading at $101.
Using the same analysis as shown above, the call option will now be worth $1 (or $100 total). The strike price is very close to the market price. Since the investor spent $200 to purchase the option in the first place, he or she will show a on this trade of $1 (or $100 total). This option would be called “ ,” because the transaction is essentially a .
When the option expires, IBM is trading at or below $100.
Here, the strike price is higher than the market price. If IBM ends up at or below $100 on the option's date, then the contract will expire “out of the money.” It will now be worthless, so the option buyer will lose 100% of his or her money (in this case, the full $200 that he or she spent for the option).