Options

Section: Options Estimated study time: 45 minutes Content: An option is a contract that gives the buyer (holder) the right — but not the obligation — to buy or sell an underlying asset at a specified price (exercise or strike price) on or before a specified date (expiration date). The seller (writer) of the option receives a premium upfront and assumes the obligation to fulfill the contract if exercised. A call option gives the holder the right to buy; a put option gives the holder the right to sell. An American option can be exercised at any time before expiration; a European option can only be exercised at expiration. Options are non-linear derivatives: the buyer's maximum loss is limited to the premium paid, while the seller's maximum profit is the premium received — but the seller faces potentially unlimited loss (for call writers) or substantial loss (for put writers). Options are characterized by their moneyness. A call option is in-the-money (ITM) when S > X (stock price above strike); at-the-money (ATM) when S ≈ X; out-of-the-money (OTM) when S < X. A put option is ITM when S < X; ATM when S ≈ X; OTM when S > X. An option's total premium consists of intrinsic value and time value. Intrinsic value = max(0, S – X) for calls and max(0, X – S) for puts. Time value = Premium – Intrinsic value; it reflects the probability that the option will become profitable (or more profitable) before expiration. Time value decays over time (theta decay), reaching zero at expiration when the option is worth only its intrinsic value. Time value is highest for ATM options and declines for…