Options Basics

Options are derivative securities that give holders the right—but not the obligation—to buy or sell an underlying asset at a specified price before a certain date. While the SIE exam covers options at a basic level, understanding key concepts like calls, puts, premiums, and intrinsic value is essential.

What Is an Option?

An option is a contract that gives the buyer the right (not obligation) to buy or sell an underlying security at a predetermined price within a specific time frame.

Key Option Components

Calls vs. Puts

There are two types of options:

Call Options

A call option gives the buyer the right to buy the underlying security at the strike price.

• Buyer (holder): Has the right to buy
• Seller (writer): Has the obligation to sell if exercised
• Bullish: Buyers expect the price to rise

Memory Tip: "Call up" — You call to buy something and want prices to go up.

Put Options

A put option gives the buyer the right to sell the underlying security at the strike price.

• Buyer (holder): Has the right to sell
• Seller (writer): Has the obligation to buy if exercised
• Bearish: Buyers expect the price to fall

Memory Tip: "Put down" — You put (sell) something and want prices to go down.

Rights vs. Obligations

Option Premium

The premium is the price paid by the buyer to the seller for the option contract.

$\text{Premium} = \text{Intrinsic Value} + \text{Time Value}$

Intrinsic Value

Intrinsic value is the amount by which an option is "in the money"—the built-in profit if exercised immediately.

For Call Options: $\text{Intrinsic Value} = \text{Market Price} - \text{Strike Price} \text{ (if positive)}$

For Put Options: $\text{Intrinsic Value} = \text{Strike Price} - \text{Market Price} \text{ (if positive)}$

Example: Stock trades at $55. A call with a $50 strike has intrinsic value of $5 ($55 - $50). A put with a $60 strike has intrinsic value of $5 ($60 - $55).

Time Value (Extrinsic Value)

Time value is the portion of the premium above intrinsic value. It reflects the possibility that the option could become more valuable before expiration.

• More time until expiration = More time value
• As expiration approaches, time value decays toward zero
• At expiration, an option has no time value—only intrinsic value (if any)

In, Out, and At the Money

Options are classified by the relationship between the strike price and market price:

Call Options

Put Options

Key Point: Only in-the-money options have intrinsic value. Out-of-the-money options have only time value.

Exercise Styles

American Style

American-style options can be exercised at any time before expiration.

• Most equity (stock) options are American-style
• More flexibility for the holder
• Generally more valuable than European-style

European Style

European-style options can only be exercised at expiration.

• Most index options are European-style
• Less flexibility for the holder
• Cannot be exercised early

Standard Contract Size

One equity option contract typically represents 100 shares of the underlying stock.

Example: If you buy 1 call option for a $2 premium, you pay $200 total ($2 × 100 shares). This gives you the right to buy 100 shares at the strike price.

Option Positions Summary

Key Takeaways

• Calls give the right to buy; puts give the right to sell
• Buyers have rights; sellers have obligations
• Premium = Intrinsic value + Time value
• In-the-money options have intrinsic value
• Time value decays as expiration approaches
• American options can be exercised anytime; European only at expiration
• One standard contract = 100 shares