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Options Basics

Exercise Price (Strike Price)

  • Definition: The predetermined price at which the underlying asset can be bought (for a call option) or sold (for a put option) if the option is exercised.

  • Significance: The strike price, along with the current price of the underlying asset, determines whether an option is "in the money," "at the money," or "out of the money."

    • In the Money (ITM):
      • Call Option: The strike price is below the current market price of the underlying asset.
      • Put Option: The strike price is above the current market price of the underlying asset.
      • An ITM option has intrinsic value.
    • At the Money (ATM):
      • The strike price is equal to the current market price of the underlying asset.
      • An ATM option has little to no intrinsic value but still has time value.
    • Out of the Money (OTM):
      • Call Option: The strike price is above the current market price of the underlying asset.
      • Put Option: The strike price is below the current market price of the underlying asset.
      • An OTM option has no intrinsic value and only time value.

Expiration Date

  • Definition: The last day on which the option can be exercised.
  • Significance: The time remaining until expiration affects the option's value. As the expiration date approaches, the time value of the option decreases (time decay).
  • Standardized Expiration: Exchange-traded options have standardized expiration dates, typically the third Friday of the expiration month.

Option Premium

  • Definition: The price the buyer pays to the seller (writer) of the option for the right to buy or sell the underlying asset.
  • Components:
    • Intrinsic Value: The amount by which the option is in the money.
      • Call Option Intrinsic Value: Max(0, Underlying Asset Price - Strike Price)
      • Put Option Intrinsic Value: Max(0, Strike Price - Underlying Asset Price)
    • Time Value: The portion of the premium that is not intrinsic value. It reflects the possibility that the option may become profitable before expiration. Factors influencing time value include time to expiration, volatility of the underlying asset, interest rates, and dividends.

Example:

  • A call option on XYZ stock has a strike price of $50.
  • XYZ stock is currently trading at $55.
  • The option premium is $7.

Intrinsic Value: $55 - $50 = $5 Time Value: $7 - $5 = $2

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