SkarpChapter 13 of 27
Options Basics: Calls, Puts, and Option Mechanics
Build a solid foundation in options by breaking down what call and put contracts represent, how they trade, and who bears which risks.
Big Picture: What Are Options and Why Do They Matter?
From Funds to Derivatives
You are moving from pooled products (mutual funds, ETFs, UITs) into derivatives, starting with options, a major SIE topic that blends products, risk, and basic math.
What Is an Option?
An option is a contract whose value is derived from an underlying asset (like a stock or ETF). It does not give ownership of the underlying; it is a contract about the underlying.
Two Basic Types
There are two basic options: a call gives the right to buy the underlying; a put gives the right to sell the underlying, both at a set price and by a set date.
Contract Size
Standard U.S. equity option contracts generally control 100 shares of the underlying, unless adjusted for events like stock splits or mergers.
Four Core Positions
You must master four positions: long call, short call, long put, and short put. Each has different rights, obligations, risks, and payoff patterns at expiration.
Option Contract Specs and Key Terminology
Key Building Blocks
Every option is defined by its underlying, contract size, strike price, expiration date, premium, and style (American or European). These are standardized in U.S. markets.
Underlying & Size
The underlying is the asset the option references (e.g., XYZ stock). Standard equity options usually control 100 shares per contract.
Strike & Expiration
The strike price is the fixed buy/sell price. The expiration date is the last day the option can be exercised before it becomes worthless.
Premium in the Market
The premium is the option’s market price, set in the secondary market, not by the issuer. A quote of 3.50 means $350 per standard contract.
Exercise Style
American-style options can be exercised any time up to expiration; European-style only at expiration. U.S. equity options are usually American-style.
Calls: Definition, Rights, and Obligations
What Is a Call?
A call option gives its buyer the right to buy the underlying at the strike price by (or at) expiration. The seller must sell if the buyer exercises.
Call Buyer Profile
The call buyer pays the premium, has a right but no obligation, is bullish, and has limited loss (premium) with theoretically unlimited upside.
Call Seller Profile
The call seller receives the premium, has the obligation to sell if assigned, is bearish or neutral, and faces limited gain (premium) but potentially unlimited loss.
Covered vs Uncovered
A covered call writer already owns the shares, reducing risk. An uncovered (naked) call writer does not, and may face very large losses if the stock soars.
Rights vs Obligations
Always anchor on this: buyers have rights and pay premiums; sellers have obligations and receive premiums. Calls are contracts about buying the underlying.
Call Option Payoff at Expiration: Visualizing Profit and Loss
Setup: Long XYZ 50 Call
You buy 1 XYZ 50 call at 4. Contract size is 100 shares, so you pay 4 × 100 = $400, your maximum possible loss.
Case 1: Stock ≤ 50
If the stock is at or below 50 at expiration, you would not exercise. The option expires worthless and your P/L is −$400.
Case 2: Stock > 50
If the stock is above 50, the call is in the money. Intrinsic value = (S − 50) × 100. Net P/L = intrinsic value − $400 premium.
Example Outcomes
At S = 55, you net +$100. At S = 60, you net +$600. Gains grow as the stock rises further above the strike.
Break-Even for Long Call
Break-even = strike + premium = 50 + 4 = 54. Below 54 you lose money; above 54 the position is profitable at expiration.
Puts: Definition, Rights, and Obligations
What Is a Put?
A put option gives its buyer the right to sell the underlying at the strike by (or at) expiration. The writer must buy if the buyer exercises.
Put Buyer Profile
The put buyer pays the premium, has a right but no obligation, is bearish, and has limited loss (premium) but potentially large gain if the stock falls sharply.
Put Seller Profile
The put seller receives the premium, must buy if assigned, is bullish or neutral, and faces large but bounded loss if the stock collapses.
Insurance Analogy
A long put is like insurance: you pay a premium to guarantee a minimum sale price. A short put is like selling that insurance.
Rights vs Obligations Reminder
Again: buyers have rights and pay premiums; sellers have obligations and receive premiums. Puts are contracts about selling the underlying.
Put Option Payoff at Expiration: Visualizing Profit and Loss
Setup: Long ABC 40 Put
You buy 1 ABC 40 put at 3. With 100 shares per contract, you pay 3 × 100 = $300, which is your maximum loss.
Case 1: Stock ≥ 40
If the stock is at or above 40 at expiration, you do not exercise. The put expires worthless and your P/L is −$300.
Case 2: Stock < 40
If the stock is below 40, the put is in the money. Intrinsic value = (40 − S) × 100. Net P/L = intrinsic value − $300.
Example Outcomes
At S = 35 you net +$200; at S = 20 you net +$1,700. Profits grow as the stock price falls further below the strike.
Break-Even for Long Put
Break-even = strike − premium = 40 − 3 = 37. Above 37 you lose money; below 37 the position is profitable at expiration.
Intrinsic Value, Time Value, and Moneyness
Intrinsic Value Basics
Intrinsic value is how much an option is in the money: for calls max(0, S − K); for puts max(0, K − S).
Moneyness Terms
An option is ITM if it has intrinsic value, ATM if stock ≈ strike, and OTM if it has no intrinsic value.
Examples of Moneyness
With strike 50 and stock 55, the 50 call is ITM by 5; the 50 put is OTM. With stock 45, the 50 put is ITM by 5; the 50 call is OTM.
Time Value
Time value = premium − intrinsic. It reflects time to expiration, expected volatility, and other factors like rates and dividends.
Premium at Expiration
Total premium equals intrinsic plus time value. At expiration, time value is zero; an option is worth only its intrinsic (or zero if OTM).
Thought Exercise: Who Wants What?
Use this exercise to lock in who benefits from which price move. Try to answer mentally before revealing your reasoning.
- Scenario A
- You are long 1 LMN 30 call.
- Question: Do you want LMN stock to rise, fall, or stay flat before expiration?
- Think: A call is the right to buy at 30. Rising prices make that right more valuable.
- Answer: You want the stock to rise.
- Scenario B
- You are short 1 LMN 30 call.
- Question: Do you want LMN stock to rise, fall, or stay flat?
- Think: You have the obligation to sell at 30 if assigned. Rising prices hurt you.
- Answer: You want the stock to fall or stay flat.
- Scenario C
- You are long 1 QRS 80 put.
- Question: Do you want QRS stock to rise, fall, or stay flat?
- Think: A put is the right to sell at 80. Falling prices make that right more valuable.
- Answer: You want the stock to fall.
- Scenario D
- You are short 1 QRS 80 put.
- Question: Do you want QRS stock to rise, fall, or stay flat?
- Think: You must buy at 80 if assigned. Falling prices hurt you.
- Answer: You want the stock to rise or stay flat.
Mental shortcut:
- Long call / short put = bullish.
- Long put / short call = bearish.
Quiz 1: Rights, Obligations, and Moneyness
Check your understanding of basic option mechanics.
An investor buys 1 XYZ 60 put at 5 when XYZ is trading at 58. Which of the following statements is TRUE at the time of purchase?
- The put is in the money by 2 points and has 3 points of time value.
- The put is out of the money by 2 points and has 5 points of time value.
- The put is at the money and has 5 points of intrinsic value.
- The put is in the money by 5 points and has 2 points of time value.
Show Answer
Answer: A) The put is in the money by 2 points and has 3 points of time value.
For a put, intrinsic value = max(0, K − S) = 60 − 58 = 2. The premium is 5, so time value = 5 − 2 = 3. That means the option is in the money by 2 points and has 3 points of time value. The buyer has the right to sell at 60, not an obligation; the seller has the obligation to buy if assigned.
Quiz 2: Profit/Loss and Break-Even
Apply payoff logic at expiration.
An investor sells 1 ABC 50 call at 6 when ABC is trading at 48. What is the investor’s profit or loss at expiration if ABC closes at 58, ignoring commissions?
- Profit of $600
- Profit of $200
- Loss of $200
- Loss of $600
Show Answer
Answer: C) Loss of $200
The investor is short a call with strike 50 and received a premium of 6 ($600). At expiration with stock at 58, the call is in the money by 8 points. The call will be exercised and the writer loses 8 × 100 = $800 on the stock side but keeps the $600 premium. Net result: −800 + 600 = **−$200**, a $200 loss.
Key Terms Review: Options Basics
Flip through these cards to reinforce core terminology you will see on the SIE.
- Call option
- A derivative contract giving the buyer the right, but not the obligation, to buy the underlying asset at a specified strike price by (or at) a specified expiration date; the seller has the obligation to sell if exercised.
- Put option
- A derivative contract giving the buyer the right, but not the obligation, to sell the underlying asset at a specified strike price by (or at) a specified expiration date; the seller has the obligation to buy if exercised.
- Strike (exercise) price
- The fixed price at which the holder of a call can buy, or the holder of a put can sell, the underlying asset if the option is exercised.
- Expiration date
- The last date on which an option can be exercised; after this date, the option ceases to exist and any remaining time value is zero.
- Option premium
- The market price of an option, paid by the buyer to the seller; equal to intrinsic value plus time value.
- Intrinsic value (call)
- For a call option, the amount by which the underlying asset’s market price exceeds the strike price, or zero if the option is out of the money.
- Intrinsic value (put)
- For a put option, the amount by which the strike price exceeds the underlying asset’s market price, or zero if the option is out of the money.
- Time value
- The portion of an option’s premium that exceeds its intrinsic value, reflecting time to expiration, expected volatility, and other pricing factors.
- In the money (ITM)
- A status where exercising the option would have positive intrinsic value: stock price above strike for calls, or below strike for puts.
- Out of the money (OTM)
- A status where exercising the option would have no intrinsic benefit: stock price at or below strike for calls, or at or above strike for puts.
- At the money (ATM)
- A status where the underlying asset’s market price is approximately equal to the option’s strike price, so intrinsic value is near zero.
- American-style option
- An option that can be exercised at any time up to and including its expiration date; most U.S. exchange-traded equity options are American-style.
- European-style option
- An option that can only be exercised on its expiration date; common for some index options.
Key Terms
- option
- A derivative contract that gives the buyer a right and the seller an obligation regarding the purchase or sale of an underlying asset at a specified strike price by or at a specified expiration date.
- put option
- A derivative contract giving the buyer the right, but not the obligation, to sell the underlying asset at a specified strike price by (or at) a specified expiration date; the seller has the obligation to buy if exercised.
- time value
- The portion of an option’s premium that exceeds its intrinsic value, reflecting time to expiration, expected volatility, and other pricing factors.
- call option
- A derivative contract giving the buyer the right, but not the obligation, to buy the underlying asset at a specified strike price by (or at) a specified expiration date; the seller has the obligation to sell if exercised.
- strike price
- The fixed price at which the holder of a call can buy, or the holder of a put can sell, the underlying asset if the option is exercised.
- option premium
- The market price of an option, paid by the buyer to the seller; equal to intrinsic value plus time value.
- expiration date
- The last date on which an option can be exercised; after this date, the option ceases to exist and any remaining time value is zero.
- intrinsic value
- The amount by which an option is in the money: for calls, max(0, S − K); for puts, max(0, K − S).
- at the money (ATM)
- A status where the underlying asset’s market price is approximately equal to the option’s strike price, so intrinsic value is near zero.
- in the money (ITM)
- A status where exercising the option would have positive intrinsic value: stock price above strike for calls, or below strike for puts.
- American-style option
- An option that can be exercised at any time up to and including its expiration date; most U.S. exchange-traded equity options are American-style.
- European-style option
- An option that can only be exercised on its expiration date; common for some index options.
- out of the money (OTM)
- A status where exercising the option would have no intrinsic benefit: stock price at or below strike for calls, or at or above strike for puts.