Options are contracts that give the owner of a stock the right to buy (call options) or sell (put options) another security at a predetermined price, called the strike price. Stock options are the most common, but option contracts are also traded on futures, foreign currency, and other securities. Employee stock options are not traded, but instead function as a special form of call option. Options don't automatically have value, so it's important for an investor to know when an option does have value and how it is calculated. All options have an expiration date after which an option that has not been exercised loses any value it had.
Understand how option prices are determined. The simplest situation is a call option issued with the strike price set at the current market price. When the seller of an option (called a writer) issues the contract, she charges a premium to cover expenses. For stock options this is usually less than $1/share. As long as the market price remains at or below the strike price, the option has zero value, because you can buy the shares on the market for the same or less than you can using the option. However, if the market price goes up at least enough to cover the premium you are "in the money." You can then buy the shares at the strike price and resell them for more than the strike price plus premium.
Know how put options work. Essentially it's just the reverse of a call option. A put option guarantees you can sell the underlying security for a specific price. If the market price falls enough to cover the premium you can buy the security on the market and sell it at a profit to the option writer (who must complete the transaction if you choose to exercise the option).
Calculate call option value and profit by subtracting the strike price plus premium from the market price. For example, say a call stock option has a strike price of $30/share with a $1 premium and you buy the option when the market price is also $30. You invest $1/share to pay the premium. If the stock then goes up to $35/share and you exercise the option, you pay the strike price of $30/share then sell the shares for $35/share. The value of the option is $5/share and your profit is this amount minus the premium of $1/share, or $4/share. Again, a put option works the same way as a call option, in reverse.
Determine net gain in the value of an option when the contract has a net value when you purchase it. Options may be issued or traded on an options exchange when the strike price and market price are different. In this case you must pay the premium plus any value the option already has. The price must go up enough (or down for put options) to put you in the money before you can make a profit. For example, if you bought a stock call option with a strike price of $30/share and a market price of $35/share, it already has a value of $5/share and you must pay this amount plus the premium (a total of $6/share). If the stock goes up to $40 share, the value of the option increases from $5/share to $10/share. Your profit, if you then exercise the option, is $10/share minus the $6 you paid, or $4/share.
Employee stock options usually have some special features, but work like call options. The options are normally given to the employee so there is no premium to pay. To calculate the value of an employee stock option, follow the same procedure used for traded call options.