BEYOND THE CHART · CHAPTER 04
Options Foundations
The learner can explain what an option is, distinguish calls from puts, compare option buyers and writers, define strike price and expiration, describe premiums, classify moneyness, separate intrinsic from extrinsic value, read basic payoff diagrams, and understand exercise and assignment. The chapter remains educational and does not recommend options trading or provide strategy advice.
An option is a contract with rights and obligations
Define an option contract.
An option is a contract between a buyer and a seller. The buyer pays a premium for a right, and the seller receives the premium and takes on a potential obligation. The contract is based on an underlying asset, such as a stock, ETF or index. Options are standardised for exchange-traded markets but can also exist over the counter.
A call option is the right to buy
Define a call option.
A call option gives the buyer the right, but not the obligation, to buy the underlying at a specified strike price. American-style contracts may generally be exercised on or before expiration; European-style contracts may generally be exercised only at expiration. A call buyer may benefit if the underlying rises sufficiently, while an assigned call writer must fulfil the contract terms.
A put option is the right to sell
Define a put option.
A put option gives the buyer the right, but not the obligation, to sell the underlying at a specified strike price. Exercise timing depends on the contract style. A put buyer may benefit if the underlying falls sufficiently, while an assigned put writer must fulfil the contract terms.
Buyers have rights, writers have obligations
Compare option buyers and writers.
For a purchased option position that is closed or expires without exercise, the loss is generally limited to the premium paid plus transaction costs. Exercise can create an underlying position with new risks. Option writers receive premium but accept assignment obligations; an uncovered call can have theoretically unlimited loss.
Strike price is the agreed transaction price
Define strike price.
The strike price is the price at which the underlying asset may be bought or sold if the option is exercised. It is fixed when the option is created. Call strikes matter when the underlying price is above them; put strikes matter when the underlying price is below them.
Expiration sets the time limit
Define expiration.
Expiration ends the option contract, but broker procedures and OCC’s exercise-by-exception process may cause certain in-the-money positions to be exercised unless contrary instructions apply. Exercise style and cut-off times differ. Time remaining affects premium, and extrinsic value generally declines as expiration approaches, all else equal.
Premium is the market price of the option
Explain option premium.
The premium is the price paid by the option buyer to the writer. It is influenced by the underlying price, strike price, time to expiration, volatility, interest rates and dividends. Premium is not a fee; it is the market price of the option contract.
Moneyness: ITM, ATM, OTM
Classify options by moneyness.
Moneyness compares the strike price with the current underlying price. A call is in the money (ITM) if the underlying price is above the strike. A put is ITM if the underlying price is below the strike. At the money (ATM) means the underlying price is near the strike. Out of the money (OTM) means the opposite relationship.
Intrinsic value and extrinsic value
Separate intrinsic from extrinsic premium.
Intrinsic value is the amount an option would be worth if exercised immediately. For an ITM call, intrinsic value is the underlying price minus the strike. For an ITM put, it is the strike minus the underlying price. Extrinsic value, or time value, is the remaining premium beyond intrinsic value.
Call payoff diagram
Read a call payoff at expiration.
At expiration, a long call’s payoff depends on the underlying price relative to the strike. If the price is below the strike, the call expires worthless and the loss is the premium paid. Above the strike, each dollar above adds a dollar of payoff, reduced by the premium paid. The diagram shows limited downside and theoretically unlimited upside for the buyer.
Put payoff diagram
Read a put payoff at expiration.
At expiration, a long put’s payoff depends on the underlying price relative to the strike. If the price is above the strike, the put expires worthless and the loss is the premium paid. Below the strike, each dollar below adds a dollar of payoff, reduced by the premium paid. The long put has limited loss and a maximum gain limited by the underlying reaching zero.
Exercise and assignment
Explain exercise and assignment.
Exercise occurs when an option buyer uses the right to buy or sell the underlying at the strike price. Assignment occurs when an option writer is required to fulfil that obligation. Not all options are exercised; many are sold or expire worthless before expiration. Exercise and assignment are more common near expiration, especially for ITM options.