With options, do supply and demand affect the price as they do for stocks? Obviously, if there is a large number of purchase orders in a stock, the price will increase. Does this hold true also if there are a large number of purchase orders for an option, or are options independent of supply and demand?

-- D.P.

Demand certainly does affect the price of an option but not necessarily in the same way it influences a stock's price. Unlike the underlying stock, which has a fixed number of shares or supply, there is no limit to the number of options contracts that can be made available for trading. As long as there are two willing parties, a buyer and a seller, a new options contract can be created. A company would need to issue more shares to increase the supply.

The reason options have a limitless supply is that they are a zero-sum game. There is no creation or destruction of capital; the losers pay the winners. Owning a stock allows one to participate in the profits or incur the losses of the business.

While in theory stocks find the fair value intersection of supply and demand, there are frequent situations in which a limitation on supply, in the form of a small float (shares available to trade), can lead to an unjustifiable or artificial increase in price, commonly referred to as a short squeeze. A short squeeze is analogous to the hoarding of a scarce resource; a true open market of supply meeting demand is not in effect.

Having a limitless supply of product for sale obviously changes the supply/demand dynamic. You could argue that it makes for a more accurate price discovery mechanism. Demand (or supply) can always be met for whatever price the market will bear. Although relentless buying will surely drive up the price of an option, it is impossible to corner an options market.

The supply of and demand for an option become known, or are measured by, the implied volatility. A large purchase order drives up the price of the options and implied volatility will increase. A large sale will drive the price down, causing a contraction in the implied volatility component of an option's valuation. Remember, implied volatility is a measure of an

expected

price move. The price of the underlying shares has an obvious impact on the value of the related options, but the price or supply and demand of the option has little or no impact on the valuation of the stock.

This distinction between

causation

, a stock price impacting an option's price, and

expectation

is most evident prior to the release of news or data that will affect the company's potential earnings. Typically, the stock price, or the valuation of the company, will remain relatively unchanged but the related options' prices can increase dramatically ahead of the news. Because of this, options sometimes are considered "predictive."

Would your conclusion about buying in-the-money options apply to puts as well? I've been considering buying puts on Global Crossing (GLBC) , but I find that in-the-money November puts, for example, have little intrinsic value and a high time value that is going to decay fast. Which puts (month/strike) would you consider to be more favorably priced? Thanks, and keep up the good work -- I've learned a lot from you!

-- J.B.

This reader is referring to

a column from earlier this week in which I suggested using options to profit from an earnings surprise. If you were expecting a negative earnings surprise, I would suggest buying puts that have a slightly in-the-money strike to take advantage of the expected price decline.

Generally speaking, when one is establishing a relatively short-term directional bet, it is best to use options closer to the money than those with strikes way out of the money. This is for the simple reason that the former have a higher delta and therefore will enjoy a greater absolute change in value relative to a change in the underlying stock price.

Too often, investors buy out-of-the-money options simply because they have a lower absolute cost than those that are near the money. One of the most common complaints of individuals who buy options is that the options "don't work" when they experience a situation in which the buyer accurately predicted the direction and even the magnitude of movement in the underlying share price, but the option's value barely changed. Way out-of the-money options are best used for:

    long-dated expirations that allow time for the predicted price move to occur; very high-beta stocks whose price can undergo double-digit percentage changes on any given day; employing "what if" insurance in case of a catastrophe; installing upside protection on a short position in case of a potential melt-up resulting from a short squeeze, favorable ruling or other parabolic-inducing influences.

Now for the pricing of Global Crossing puts. On Wednesday, with the stock trading at $14.30, I saw the November $15 put, which is 70 cents in the money, trading at $1.40 per contract. That means half of its value is intrinsic.

Remember that because a put option is the right (but not the obligation) to sell stock at the designated strike price, the higher the strike price the deeper in the money or the greater the intrinsic value. For example, Global Crossing's November $17.50 put was trading at $3.40, meaning it had $3.20 of intrinsic value and just 20 cents of time value. The $12.50 put was trading at 35 cents. Because it is out of the money, it has no intrinsic value, so its value is comprised mostly of time value.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.