6.2 Options Basics
Key Takeaways
A CALL option gives the holder the right to BUY at the strike price.
A PUT option gives the holder the right to SELL at the strike price.
Option BUYERS have rights; option SELLERS (writers) have obligations.
Maximum loss for option BUYERS is the premium paid.
Maximum loss for NAKED CALL writers is theoretically unlimited.
Intrinsic value: For calls, (if positive); for puts, .
Time value formula: ; decreases as expiration approaches.
Call breakeven: ; Put breakeven: .
Options are derivative contracts giving the holder the right (but not obligation) to buy or sell an underlying asset at a specified price.
Option Fundamentals
Key Definitions
| Term | Definition |
|---|---|
| Call Option | Right to BUY at the strike price |
| Put Option | Right to SELL at the strike price |
| Strike Price | Price at which option can be exercised |
| Premium | Price paid for the option contract |
| Expiration | Last day option can be exercised |
| Underlying | The security the option is based on |
Rights vs. Obligations
| Position | Rights/Obligations | Payment |
|---|---|---|
| Buyer (Long) | Has the RIGHT to exercise | PAYS premium |
| Seller (Writer) | Has the OBLIGATION if exercised | RECEIVES premium |
Call Options
A call option gives the holder the right to BUY the underlying asset at the strike price.
Call Option Positions
| Position | Market View | Max Loss | Max Gain |
|---|---|---|---|
| Long Call (Buyer) | Bullish | Premium paid | Unlimited |
| Short Call (Writer) | Bearish/Neutral | Unlimited (if naked) | Premium received |
Long Call Analysis
Scenario: Buy ABC 50 Call for $3
| Stock Price at Expiration | Intrinsic Value | Profit/Loss |
|---|---|---|
| $40 | $0 | -$3 (lose premium) |
| $50 | $0 | -$3 (lose premium) |
| $53 | $3 | $0 (breakeven) |
| $60 | $10 | +$7 |
When to Buy Calls
| Reason | Explanation |
|---|---|
| Bullish outlook | Expect stock to rise |
| Leverage | Control shares with less capital |
| Limited risk | Maximum loss is premium |
| Speculation | Profit from price movement |
Put Options
A put option gives the holder the right to SELL the underlying asset at the strike price.
Put Option Positions
| Position | Market View | Max Loss | Max Gain |
|---|---|---|---|
| Long Put (Buyer) | Bearish | Premium paid | Strike - Premium |
| Short Put (Writer) | Bullish/Neutral | Strike - Premium | Premium received |
Long Put Analysis
Scenario: Buy XYZ 50 Put for $2
| Stock Price at Expiration | Intrinsic Value | Profit/Loss |
|---|---|---|
| $55 | $0 | -$2 (lose premium) |
| $50 | $0 | -$2 (lose premium) |
| $48 | $2 | $0 (breakeven) |
| $40 | $10 | +$8 |
When to Buy Puts
| Reason | Explanation |
|---|---|
| Bearish outlook | Expect stock to decline |
| Portfolio protection | Hedge long stock positions |
| Limited risk | Maximum loss is premium |
| Speculation | Profit from downside |
Exam Tip: Call buyers are BULLISH. Put buyers are BEARISH. Remember: "Call up, Put down."
Intrinsic Value and Time Value
An option's premium consists of intrinsic value and time value.
Intrinsic Value
| Option Type | Intrinsic Value Formula |
|---|---|
| Call | (if positive) |
| Put | (if positive) |
Intrinsic value cannot be negative - minimum is zero.
Time Value
| Factor | Effect on Time Value |
|---|---|
| Time to Expiration | More time = More value |
| Volatility | Higher volatility = More value |
| Interest Rates | Affects call/put differently |
Calculation Examples
Call Example: Stock at $55, 50 Call trading at $8
- Intrinsic value = $55 - $50 = $5
- Time value = $8 - $5 = $3
Put Example: Stock at $45, 50 Put trading at $7
- Intrinsic value = $50 - $45 = $5
- Time value = $7 - $5 = $2
Option Moneyness
| Status | Call Option | Put Option |
|---|---|---|
| In The Money (ITM) | Stock > Strike | Stock < Strike |
| At The Money (ATM) | Stock = Strike | Stock = Strike |
| Out of The Money (OTM) | Stock < Strike | Stock > Strike |
ITM, ATM, OTM Examples (Strike = $50)
| Stock Price | Call Status | Put Status |
|---|---|---|
| $55 | In The Money | Out of The Money |
| $50 | At The Money | At The Money |
| $45 | Out of The Money | In The Money |
Exam Tip: In-the-money options have intrinsic value. Out-of-the-money options have NO intrinsic value (only time value).
Breakeven Points
| Position | Breakeven Formula |
|---|---|
| Long Call | |
| Long Put | |
| Short Call | |
| Short Put |
Maximum Gain and Loss
| Position | Maximum Gain | Maximum Loss |
|---|---|---|
| Long Call | Unlimited | Premium paid |
| Short Call (Naked) | Premium | Unlimited |
| Long Put | Premium paid | |
| Short Put | Premium |
Basic Option Strategies
Covered Call
- Own stock + Write (sell) call
- Goal: Generate income from premium
- Risk: Stock called away if price rises
- Max Gain:
- Max Loss:
Protective Put
- Own stock + Buy put
- Goal: Protect against downside
- Cost: Premium paid for insurance
- Like: Buying insurance on your stock
- Max Loss:
Exam Tip: Know the maximum gain, maximum loss, and breakeven for each basic position. These are frequently tested.
An investor buys a call option with a strike price of $50 for a premium of $3. What is the breakeven point?
$47
$50
$53
$56
A stock is trading at $48. A 50 put option has a premium of $5. What is the intrinsic value and time value?
Intrinsic: $0, Time: $5
Intrinsic: $2, Time: $3
Intrinsic: $5, Time: $0
Intrinsic: $3, Time: $2
What is the maximum loss for the writer of a naked call option?
The premium received
The strike price
The strike price minus the premium
Theoretically unlimited
An investor who is bullish on a stock would most likely:
Buy a put option
Sell a call option
Buy a call option
Sell stock short
Sections you finish are checked off in the contents.