8.1 Options Basics

What an Option Is

An option is a derivative contract giving the holder the right, but not the obligation, to buy or sell an underlying security at a fixed strike price until expiration. Options are among the most heavily tested Series 7 topics, and the 125-question, 225-minute exam (72% to pass) typically devotes roughly 10% of items to them. One listed equity option contract covers 100 shares, so a premium quoted as $3 costs $3 x 100 = $300.

Calls vs. Puts

A call option gives the buyer the right to buy 100 shares at the strike. A put option gives the buyer the right to sell 100 shares at the strike.

• Call buyers are bullish — they profit when the stock rises above the strike.
• Call writers (sellers) are bearish to neutral — they want the stock flat or lower.
• Put buyers are bearish — they profit when the stock falls below the strike.
• Put writers (sellers) are bullish to neutral — they want the stock flat or higher.

Memory tip: "Call up, put down." Calls gain when the stock goes up; puts gain when it goes down.

Buyers (Long) vs. Writers (Short)

Every contract has two sides. The buyer is long and holds the rights; the writer is short and carries the obligations.

Reading a Contract

An option is quoted as issuer, expiration month, strike, type, premium — for example, "1 ABC Oct 50 call @ 3." Standard listed equity options expire the third Friday of the expiration month; the customer's broker accepts final exercise instructions until 5:30 PM ET that day, after which the OCC processes expiration.

Exam alert: Buyers pay and have rights; writers receive and have obligations. The exam reverses these constantly to catch careless readers. A "writer" and a "seller" are the same party.

Opening and Closing Transactions

The exam labels every options order by intent. An opening transaction establishes a new position; a closing transaction offsets one the customer already holds. There are four combinations:

A writer who wants out of a short call does not exercise — the writer cannot — but instead places a closing purchase of the identical contract. Likewise a holder who no longer wants a long put places a closing sale rather than waiting to exercise.

Common Traps

• A call writer is not bullish — the writer wants the call to expire worthless and keep the premium.
• The 100-share multiplier means a "$2 premium" question almost always wants $200, not $2.
• A holder closes a long option with a sale; a writer closes a short option with a purchase — reversing these is a classic distractor.
• Listed options of the same class and series are fungible, which is exactly why the OCC can guarantee them and why a closing trade simply nets against the open position.

Moneyness

Moneyness compares the current stock price to the strike to determine whether exercising would produce value. It is the foundation for every payoff calculation later in this chapter.

Calls (strike = $50)

Puts (strike = $50)

Memory tip: Calls are ITM when the stock is UP (above strike); puts are ITM when the stock is DOWN (below strike).

Intrinsic Value and Time Value

Every premium splits into two parts:

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

Intrinsic value is the amount an option is in-the-money. It can never be negative — the floor is zero.

• Call intrinsic value = Stock price − Strike (if positive, else 0)
• Put intrinsic value = Strike − Stock price (if positive, else 0)

Time value is whatever the premium exceeds intrinsic value:

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

Time value reflects the chance the option moves further into the money before expiration. It is largest for at-the-money contracts and erodes as expiration nears — a process called time decay (theta). An OTM option has zero intrinsic value, so its entire premium is time value.

Worked example

XYZ trades at $53. An XYZ 50 call trades at $5.

• Intrinsic value: $53 − $50 = $3 (the call is $3 ITM).
• Time value: $5 − $3 = $2.

If instead XYZ traded at $47, the same 50 call would have $0 intrinsic value, and any premium would be 100% time value.

Exam alert: A common distractor adds intrinsic and time value incorrectly, or assigns intrinsic value to an OTM option. Always confirm the option is ITM before computing intrinsic value, and remember intrinsic value bottoms at zero.