Call options are in the money (ITM) when the stock price is higher than the strike price.

Put options are in the money (ITM) when the strike price is higher than stock price.     

The Strike Price is the level at which an investor can exercise his rights.    

Example of an ITM Long Call option:   If a stock is trading at $50 per share on the open market and you buy a call option contract (100 shares), at $40 per share, strike price, the option is in the money. 

Why is it in the money??  Notice that the stock price is higher than the strike price. This means that You have the right to buy the underlying stock at the strike price of $40 per share and turn around and sell it on the open market at the market value of $50 per share, a gain of $10 per share, less commissions,  therefore, the option is in the money.   

Example of an ITM Long Put option:  If a stock is trading at $50 per share on the open market and you buy a put option contract(100 shares), at a $60 strike price, the option is in the money.

Why is it in the money?  Notice that the stock price is lower than the strike price.  You have the right to sell the underlying stock at the strike price of $60 per share and can buy it on the open market for $50 per share less commission, therefore, you are in the money.

Additional Examples of Calls and Puts

 Long Call
If you have a stock in mind and have a strong feeling that it might go up in value. You can either buy the stock, or buy "the right to buy the stock",  otherwise known as a long call option. Buying a call option is similar to the concept of leasing.  Like a lease, a call option gives you the benefits of owning a stock, yet requires less capital than actually buying the stock. Just as a lease has a fixed term, a call option has a limited term and expiration.

Example:  XYZ stock is trading on the open market at $50 per share.  You feel the stock will rise above $50 per share by April's expiration day.  Rather than buying the stock at $50 per share (100 x$50=$5000), you choose to buy an ITM call option at $40 per share strike price(exercise price). 

You buy an April call option at a $40 strike price, (exercise price).  Let's suppose the cost of the option (premium) is $1 per share,(100 shares will cost $100 in premium ), for 1 contract.  In March you buy 1 April 40 Call for $1 ($1x100=$100).

If the stock stays at or below $50 the option expires worthless and the premium of $100 would be lost.  If however, the stock does rises above $50 per share prior to the expiration date, say, $60 per share, based on your contract, you have the right, but not the obligation, to buy the underlying stock at the $40 per share strike price.   

You now have two choices.  1) You have the right to exercise your options and buy the stock at $40 per share, therefore, you would own the 100 shares of stock that is valued at $20 more than you paid for it, ($60-40=$20), you can hold on to it if you want to and hope it will go up more.  Or 2) you can sell it immediately on the open market for $60 per share market price which gives you $20 per share gain on the trade (minus the premium paid). 

Long Put
Now let's imagine that your feelings about that same stock is that it might go down in value.  You could buy puts (the right to sell the stock at a fixed price by a certain date).

Example: XYZ stock is trading on the open market at $50 per share.  You feel that the stock will go down below it's current $50 value by April's expiration day.  You buy an April ITM put option at a $60 strike price (exercise price).  Let's suppose the cost is $1 per share (100 shares will cost $100 in premium ) for 1 contract.  If the stock does falls to $40 per share, based on your contract, you have the right to sell the underlying stock at the $60 strike price even if the stock price falls to $0 per share.

If the stock rises above the $50, you have no obligation to sell the stock, and the contract will expire worthless and you will loose the $100 investment.

Options are not always exercised, the investor has the right to close the trade any time during the course of the contract prior to the expiration day.  If the trade become profitable or if losses are being incurred he can close the trade to capture the gains or to prevent further losses.

Closing the trade means to reverse the order of the initial trade, sell the put or the call.

Virtual Trading is a good way to practice these applications before doing any live options trading.  When you open a free account with most options houses, i.e Options Express, Think or Swim and many others, you will be able to practice on a simulated platform and most do have free option trading education, through webinars and free conferences.