2.11 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

Underlying asset: The security the option is based on (usually stock)

Strike price: The price at which the option can be exercised

Expiration date: The date the option contract expires

Premium: The price paid to purchase the option

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

Buyer: Call Option - Right to buy; Put Option - Right to sell

Seller: Call Option - Obligation to sell; Put Option - Obligation to buy

Option Premium

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

Premium = Intrinsic Value + 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:

Intrinsic Value = Market Price minus Strike Price (if positive)

For Put Options:

Intrinsic Value = Strike Price minus Market Price (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

In the money (ITM): Market price greater than Strike price; Has value

At the money (ATM): Market price = Strike price; Zero

Out of the money (OTM): Market price less than Strike price; Zero

Put Options

In the money (ITM): Market price less than Strike price; Has value

At the money (ATM): Market price = Strike price; Zero

Out of the money (OTM): Market price greater than Strike price; Zero

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 x 100 shares). This gives you the right to buy 100 shares at the strike price.

Option Positions Summary

Buy call: Market View - Bullish; Maximum Gain - Unlimited; Maximum Loss - Premium paid

Sell call: Market View - Neutral/Bearish; Maximum Gain - Premium received; Maximum Loss - Unlimited

Buy put: Market View - Bearish; Maximum Gain - Strike price minus Premium; Maximum Loss - Premium paid

Sell put: Market View - Neutral/Bullish; Maximum Gain - Premium received; Maximum Loss - Strike price minus Premium

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