A stock option may always be categorized in one of three ways: in-the-money, at-the-money, or out-of-the-money. An at-the-money option, also sometimes referred to as an on-the-money option, is one whose strike price is equal to that of the underlying stock's market value. In-the-money and out-of-the-money options are each determined in one of two ways, depending on whether the option is a call or a put.

A call option is classified as in-the-money if its strike price is less than the market value of the underlying stock. For example, an XYZ Inc. July 30 call would be in-the-money if XYZ is trading above 30.

If the strike price of a call is greater than the market value of the underlying stock, it is considered out-of-the-money. If the XYZ shares are trading below 30, the XYZ July 30 call would be out-of-the-money.

For put options, the reverse is true. A put will be in-the-money if its strike price is greater than the market value of the underlying stock and out-of-the-money if the underlying stock's value is greater than the strike price. An XYZ July 30 put, for example, will be in-the-money if XYZ is trading below 30 and out-of-the-money if XYZ is trading above 30.

A stock option's total value consists of two components: intrinsic value and time value. Options will have intrinsic value only if they are in-the-money. The intrinsic value of an in-the-money option is equal to the difference between the option's strike price and the current value of the underlying stock. For example, if ABC Corp. is trading at 69.15, an ABC May 65 call will have an intrinsic value of 4.15 (69.15 - 65 = 4.15), and an ABC May 70 put will have an intrinsic value of 0.85 (70 – 69.15 = 0.85). Obviously, the deeper a stock option is in-the-money, the higher an intrinsic value it will have.

Any value in an option above its intrinsic value is time value, and represents a price given for the amount of time an option has until expiration. Time value may be calculated by subtracting intrinsic value from total value. Continuing with our ABC Corp. example from above, if the ABC May 65 call has a total value of 7.75 with an intrinsic value of 4.15, the time value will be 3.60 (7.75 – 4.15). If the May 70 put has a total value of 3.90 with a 0.85 intrinsic value, the time value will be 3 (3.890 – 0.85 = 3.05). The more time a stock option has remaining until expiration, the higher its value will be since additional time improves the chances that the option will make the desired move.

Unlike stocks, options have a limited life. If an expected move does not immediately occur, a stock investor can say, "I'll give it another week." This is not always true with options trading. Each option has a set expiration date. At expiration, an option is either worth the difference between its strike price and the current stock price, or it's worthless.

There are a couple of key factors to keep in mind when dealing with the limited life of options. The first key factor is the understanding that an option's value depends on the ability to correctly predict both the direction and timing of a move in the price of the underlying stock.

The first variable, direction, is easily understood. If the expectation is that the underlying stock price will go up, but instead it goes down, the investor loses money. (However, an options investor could earn money if the expectation is that the underlying stock price will drop and the price does drop.)

The second key variable in options trading is the timing of the direction. For instance, the holder (buyer) of an ABC Corp. May 35 call is guaranteed the right to buy 100 shares of the stock at $35 per share at any time before the option's May expiration, even if the stock rallies to $40, $50, or even $70 per share. However, it costs more to pay for a July 35 call than a May 35 call, because of the additional time, and therefore, improved likelihood, that the stock will rally above the price of $35 per share.

Dividends are another key difference between stock and option trading. Dividends do not represent a change in value to the holder of a stock, because the stock price moves down approximately the same value as the dividend paid to the shareholder. This is not true in options. An option does not give the holder the right to receive a dividend. Thus, when a dividend is paid and the stock subsequently falls, an option holder bears the full brunt of the dividend paid. This is a negative characteristic for a holder of a call option. However, the holder of a put option, who is betting the stock will go down anyway, actually gains from this occurrence. Of course, the options market anticipates the impact of upcoming dividends and tends to discount for this effect just before the dividend is paid.

Remember, an option does not give the holder ownership rights, voting rights, or a share of the company; it entitles the owner to benefit only from the stock's price movement.