What is an Option?
An option contact is an agreement between a buyer and seller that give the buyer the right - but not the obligation - to buy or sell the underlying asset at a time in the future at an agreed price. In return the seller is paid a premium. The buyer has the ability to excercise their contract at anytime before the option expiry date, if this date passes the seller is no longer bound by the contract and keeps the premium.

There are two types of options available depending on whether the underlying asset is to be bought or sold. A Call option give the buyer the right to "buy" the underlying asset, if the seller is exercised then they are obligated to sell the underlying asset to the buyer. A Put option give the buyer the option to "Sell" the underlying asset, if the seller is exercised then they are obligated to buy the underlying security from the buyer.

How are options used?
On the Australian stock exchange one option controls 1000 shares, if you buy/sell one option contract you have the right to buy/sell 1000 shares. In the USA one option contract controls only 100 shares. An example of how options work is shown below

Say shares in company XYZ are currently trading at $20 and you own 1000 shares. If believed that the price of these shares were going to drop you could take out an option contract at $20 that gives you the right to sell your shares to someone else at some date in the future for a premium. If the share price was to halve to $10, you would be able to exercise your right to sell them to someone else at $20, therefore protecting yourself from the $10 per share loss. If the shares were to increase to $30 then you would not exercise the contract for $20, because you can get $30 on the open market. In this example a Put option was used to "insure" the shares.

A Call option could be bought if you were expecting the price of company XYZ to rise significantly in the near future, but you don't want to risk actually buying the shares. for example if a call option was taken out for $22.50 and the price of the shares increased to $30 you can buy the shares of the option seller for $22.50 and resell the shares on the open market $30.

What determines the price of Option Contracts?
Option contracts are made up of two elements, intrinsic value and time value. As time passes by the amount of time value decreases, when the option contract expires only intrinsic value is left. for example if XYZ is trading at $20 and an investor sells a call option with a strike price of $17.50 for $3.50 there is $2.50 of intrinsic value (real value) and $1 worth of time value, as the month goes on the time value will exponentially decay down to zero, so at expiry if the share is still at $20 the option contract will only be worth $2.50, check out the share insurance section to see how this can benefit the investor.

Strike Prices
There are three different price bands where options are placed, these are In The Money, Out Of The Money, and At The Money. These price bands are explained below.

In The Money (ITM)
An in the money Call option is when the strike price of the sold option is less than the share price, i.e a call option with a stirke price of $17.50 with the share price at $20. There is $2.50 of intrinsic value in the option.

 In the case of Sold Put options the strike price must be above the share price i.e $22.50. i.e there is $2.50 of intrinsic value in the option.

Out Of The Money (OTM)
An out of the money Call option is when the strike price of the sold option is greater than the share price, i.e a call option with a stirke price of $22.50 with the share price at $20. There is no intrinsic value in this option only time value.

In the case of Sold Put options the strike price must be below the share price i.e $17.50. There is no intrinsic value in this option only time value.

At The Money (ATM)
If the sold option is equal to the share price then the option is at the money.