7.1 Options Basics

Options are derivative securities - their value is derived from an underlying asset such as stocks, indexes, or ETFs. Understanding options is essential for the Series 65 because investment advisers must recognize when clients are using these instruments appropriately.

What Is an Option?

An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a specified time period.

Key Option Terminology

Premium: Price paid by buyer to seller for the option contract

Strike Price: The fixed price at which the underlying can be bought or sold

Expiration Date: The last day the option can be exercised

Underlying Asset: The security the option is based on (stock, index, ETF)

Exercise: Using the right to buy or sell the underlying

Assignment: When option seller must fulfill the contract obligation

Types of Options

Call Options

A call option gives the holder the right to BUY the underlying asset at the strike price.

Call Buyer (Long Call): Right/Obligation - Right to buy; Market Outlook - Bullish; Maximum Gain - Unlimited; Maximum Loss - Premium paid; Breakeven - Strike + Premium

Call Seller (Short Call): Right/Obligation - Obligation to sell; Market Outlook - Bearish or neutral; Maximum Gain - Premium received; Maximum Loss - Unlimited; Breakeven - Strike + Premium

Memory Tip: "Call Up" - Call buyers want the stock price to go UP.

Put Options

A put option gives the holder the right to SELL the underlying asset at the strike price.

Put Buyer (Long Put): Right/Obligation - Right to sell; Market Outlook - Bearish; Maximum Gain - Strike - Premium (stock to $0); Maximum Loss - Premium paid; Breakeven - Strike - Premium

Put Seller (Short Put): Right/Obligation - Obligation to buy; Market Outlook - Bullish or neutral; Maximum Gain - Premium received; Maximum Loss - Strike - Premium; Breakeven - Strike - Premium

Memory Tip: "Put Down" - Put buyers want the stock price to go DOWN.

Option Premium Components

The option premium consists of two components:

Intrinsic Value

Intrinsic value is the amount an option is "in the money" - the immediate profit if exercised.

For Calls: Intrinsic Value = Stock Price - Strike Price (if positive; otherwise $0)

For Puts: Intrinsic Value = Strike Price - Stock Price (if positive; otherwise $0)

Time Value

Time value (also called extrinsic value) represents the premium above intrinsic value. It reflects the probability that the option will become more profitable before expiration.

Option Premium = Intrinsic Value + Time Value

Example: A call option with a $50 strike has a $7 premium when the stock trades at $54.

- Intrinsic value = $54 - $50 = $4

- Time value = $7 - $4 = $3

Time Decay (Theta)

Options lose time value as expiration approaches - this is called time decay. Time decay accelerates as expiration nears, making options less valuable over time (all else equal).

Option Moneyness

The relationship between the stock price and strike price determines an option's "moneyness."

In the Money (ITM): Call Option - Stock greater than Strike; Put Option - Stock less than Strike; Intrinsic Value - Yes

At the Money (ATM): Call Option - Stock = Strike; Put Option - Stock = Strike; Intrinsic Value - No

Out of the Money (OTM): Call Option - Stock less than Strike; Put Option - Stock greater than Strike; Intrinsic Value - No

In Practice

An investor owns a call option with a $60 strike price:

- If the stock trades at $65: The call is in the money by $5

- If the stock trades at $60: The call is at the money

- If the stock trades at $55: The call is out of the money by $5

American vs. European Options

American: Exercise Timing - Any time before expiration. Common Usage: Most stock options

European: Exercise Timing - Only at expiration. Common Usage: Many index options

Most exchange-traded equity options in the U.S. are American-style.

Rights vs. Obligations

Understanding who has rights and who has obligations is fundamental to options:

Option Buyer (Long): Has a Right. Pays/Receives Premium: Pays premium

Option Seller (Writer/Short): Has an Obligation. Pays/Receives Premium: Receives premium

Option buyers control the contract - they decide whether to exercise. Option sellers must perform if assigned.

On the Exam

Questions often test maximum gain and maximum loss:

- Buyers: Max loss = Premium paid (defined risk)

- Sellers: Max gain = Premium received, but potentially unlimited loss (calls) or substantial loss (puts)

Key Takeaways

- Options give the holder the right, but not the obligation, to buy (call) or sell (put) an underlying asset

- Call buyers are bullish (want price to rise); put buyers are bearish (want price to fall)

- Option premium = Intrinsic Value + Time Value

- Intrinsic value: How much the option is in the money

- Time value: Premium above intrinsic value; decreases as expiration approaches

- Option buyers have limited risk (premium paid); option sellers have limited gain (premium received) but potentially larger losses

- "Call Up, Put Down" helps remember which direction benefits each option type