How are options priced and where do gains come from for these trades?

I am no real expert on this. I can talk about my own understandings, but then I could be grossly wrong :)

As far as I know, the following 5 factors affect the price of an option.

1. Price of underlying stock also referred to as security or asset
2. Option strike price
   
3. Volatility of underlying stock.
• This is amount of uncertainty associated with the stock's expected returns. Higher the volatility, more expensive the option will be.
4. Time to expiration
• The price of an option decreases as it approaches the expiration date. This ties in with the volatility. Closer the option is to the expiration date, less volatile it becomes.
  
5. Risk free rate
• I will not get into this. Usually, this is the amount of interest earned by U.S. treasury bills.

The option prices are determined by using a fairly involved formula proposed by Myron Scholes and Fischer Black in 1973.

So, assuming that the market does not move too much, there are a couple of things an investor can do to hunt for gains.

1. Look for volatile stocks. These are riskier kind, which means you could end up in big trouble by trading on these stocks. But if you can craft a careful strategy around these and if you are willing to watch the price movements very closely, the chances of a catastrophe can be reduced a bit.
   
2. Make time value of an option act in your favor. This can be done by being on the "selling side" of the options trade. The price of an option decays with time, thus acting in favor of the seller (which means if everything was to say the same, the seller can close the obligation by purchasing the sold option from the market and earning a profit by doing so)

The above 2 points form the basis of "stock picking" strategy for my portfolio. Are these risk-free in any way? Absolutely not. At the end of the day, I am trading risk for reward.
So, lets see how the portfolio does. I will keep you updated.