Options Basics
Options are derivative securities that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a specific time period. Options are among the most heavily tested topics on the Series 7 exam.
Types of Options
Call Options
A call option gives the holder (buyer) the right to buy the underlying security at the strike price before expiration.
- Call Buyers are bullish - they expect the stock price to rise
- Call Writers (Sellers) are bearish to neutral - they expect the stock to stay flat or decline
Put Options
A put option gives the holder (buyer) the right to sell the underlying security at the strike price before expiration.
- Put Buyers are bearish - they expect the stock price to fall
- Put Writers (Sellers) are bullish to neutral - they expect the stock to stay flat or rise
Memory Tip: "Call up, Put down" - Calls profit when prices go UP, Puts profit when prices go DOWN.
Key Option Components
| Component | Description |
|---|---|
| Premium | The price paid for the option contract |
| Strike Price | The price at which the option can be exercised |
| Expiration Date | The last day the option can be exercised |
| Contract Size | Typically 100 shares per contract |
Buyers vs. Writers
| Party | Rights/Obligations | Premium | Risk |
|---|---|---|---|
| Buyer (Long) | Has RIGHTS only | Pays premium | Limited to premium paid |
| Writer (Short) | Has OBLIGATIONS only | Receives premium | Can be unlimited (naked calls) |
Exam Alert: Remember that buyers have rights and pay premium, while writers have obligations and receive premium. Writers are also called sellers.
Money Status (Moneyness)
The relationship between the stock price and strike price determines whether an option is in-the-money, at-the-money, or out-of-the-money.
Call Options
| Status | Relationship | Example (Strike = $50) |
|---|---|---|
| In-the-Money (ITM) | Stock Price > Strike Price | Stock at $55 (can buy at $50) |
| At-the-Money (ATM) | Stock Price = Strike Price | Stock at $50 |
| Out-of-the-Money (OTM) | Stock Price < Strike Price | Stock at $45 (no advantage) |
Put Options
| Status | Relationship | Example (Strike = $50) |
|---|---|---|
| In-the-Money (ITM) | Stock Price < Strike Price | Stock at $45 (can sell at $50) |
| At-the-Money (ATM) | Stock Price = Strike Price | Stock at $50 |
| Out-of-the-Money (OTM) | Stock Price > Strike Price | Stock at $55 (no advantage) |
Memory Tip: "Calls - Call it UP" (ITM when stock is ABOVE strike). "Puts - Put it DOWN" (ITM when stock is BELOW strike).
Intrinsic Value and Time Value
Premium = Intrinsic Value + Time Value
Intrinsic Value
The amount by which an option is in-the-money. An option can never have negative intrinsic value (minimum is zero).
- Call Intrinsic Value = Stock Price - Strike Price (if positive)
- Put Intrinsic Value = Strike Price - Stock Price (if positive)
Time Value
The portion of the premium that exceeds intrinsic value. Represents the possibility that the option will become more valuable before expiration.
Time Value = Premium - Intrinsic Value
Example Calculation
XYZ stock is trading at $53. An XYZ 50 Call is trading at $5.
- Intrinsic Value = $53 - $50 = $3 (the call is $3 in-the-money)
- Time Value = $5 - $3 = $2
Exam Alert: Time value is highest for at-the-money options and decreases as expiration approaches (time decay or "theta decay").
An investor buys an ABC 40 Call for $3 when ABC stock is trading at $43. What is the intrinsic value of this option?
Which of the following describes a put option that is in-the-money?
An option has a premium of $7 and an intrinsic value of $4. What is the time value?
8.2 Long and Short Option Positions
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