For someone buying a put to protect a stock position in a very volatile market the option value is its insurance value as the individual only intends to exercise the put option if the spot price drops below the strike price. Similarly for someone selling a call option the option value is the premium as the selling cannot profit from a divergence of the spot price from the strike price.

Option value is different for the buyer of a call option. Here the buyer stands to make a lot of money if the spot price goes far above the strike price. The option value will, in fact, go up as the spot price goes up. Thus the option becomes more expensive to buy. As options are traded during the term of their contract an options trader need never buy or sell stock, only trade the option. For the buyer of a call option the option value can be a multiple of the premium paid if the spot price rises substantially over the strike price. The only risk for the buyer of an option is that there is no option value if the spot price does not rise above the strike price.

Generally option value is based upon the following:

• The day’s market price of the security in question
• The strike price of the option (in relation to the spot price
• Costs and profits involved in holding a position in an underlying security
• Time to expiration of the options contract
• The market estimate of what the spot price will be at the end of the contract and how much the stock will fluctuate from now to then

The ideal situation when buying a call option is that the option value is low at the beginning of the contract and as the spot price fluctuates and, hopefully, goes up the option value goes up with the spot price. When the market decides that a stock’s spot price is likely to go up or down dramatically is when the option value moves (up or down) dramatically. This is one place where fortunes are made in options trading. An payment of a premium of two to four dollars a share for a 100 share block of stock can turn into tens of dollars a share if the spot price rises substantially above the strike price.

If you bought stock at $50 a share and the spot price goes to $100 a share you are a happy investor with a 100% profit to brag about at the office. If you paid $2 a share for a call option on the same stock you will make a 25 fold or 2500% profit. In that case the option value will be such that you may be sailing your yacht around the world and no longer in the office.

You can profit from options in two basic ways. You can sell call or put options and earn a premium which is what the buyer pays in order to have the option to buy (in the case of a call option) or sell (in the case of a put option). You can also buy call or put options and have the opportunity of earning the difference between the spot price and the strike price, minus the premium you paid to get that option.

In the case of selling call options you really do not want the market price or spot price to go up so that you can earn your premium and keep your stock. You risk in selling a call option is that the stock will double in value overnight and you will miss out. In the case of buying call options you want the stock to go up more than the premium you paid so that you can exercise you option and collect the difference between the strike price (exercise price) which is what you will pay and the spot price (market price) which is what the stock will now be worth. Remember, however, that the stock needs to go up more than the premium you paid and, if you are going to immediately sell the stock, more than the premium and the commissions you will pay.

If you are selling a put option then, as with selling a call option, you will earn a premium from the buyer. However, with a put option there is a potentially large risk. If the market price (the spot price) drops substantially below the strike price (exercise price) then the buyer will exercise the option and you will need to buy the stock at the now higher strike price or exercise price and either hold on to it or sell it for a loss at the now lower market price or spot price.

If you are buying a put option you pay the premium to protect your stock position at the strike price. If the stock goes well above the spot price (exercise price) you are happy and do not exercise the option. If the stock goes well below the spot price (exercise price) then you exercise the option and the seller of the put option buys your stock at the strike price (exercise price) instead of the, now, much lower spot price.

Assuming that you are learning the terminology, the strike price or exercise price is the price at which an options contract is exercised. The spot price is the market price when the term of the option contract expires.