Options Basics

Options are derivative securities—their value is derived from an underlying asset such as stocks, indexes, or ETFs. Understanding options is essential for the Series 65 because investment advisers must recognize when clients are using these instruments appropriately.

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What Is an Option?

An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a specified time period.

Key Option Terminology

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Types of Options

Call Options

A call option gives the holder the right to BUY the underlying asset at the strike price.

Memory Tip: "Call Up" – Call buyers want the stock price to go UP.

Put Options

A put option gives the holder the right to SELL the underlying asset at the strike price.

Memory Tip: "Put Down" – Put buyers want the stock price to go DOWN.

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Option Premium Components

The option premium consists of two components:

Intrinsic Value

Intrinsic value is the amount an option is "in the money"—the immediate profit if exercised.

For Calls: Intrinsic Value = Stock Price - Strike Price (if positive; otherwise $0) For Puts: Intrinsic Value = Strike Price - Stock Price (if positive; otherwise $0)

Time Value

Time value (also called extrinsic value) represents the premium above intrinsic value. It reflects the probability that the option will become more profitable before expiration.

Option Premium = Intrinsic Value + Time Value

Example: A call option with a $50 strike has a $7 premium when the stock trades at $54.

• Intrinsic value = $54 - $50 = $4
• Time value = $7 - $4 = $3

Time Decay (Theta)

Options lose time value as expiration approaches—this is called time decay. Time decay accelerates as expiration nears, making options less valuable over time (all else equal).

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Option Moneyness

The relationship between the stock price and strike price determines an option's "moneyness."

In Practice

An investor owns a call option with a $60 strike price:

• If the stock trades at $65: The call is in the money by $5
• If the stock trades at $60: The call is at the money
• If the stock trades at $55: The call is out of the money by $5

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American vs. European Options

Most exchange-traded equity options in the U.S. are American-style.

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Rights vs. Obligations

Understanding who has rights and who has obligations is fundamental to options:

Option buyers control the contract—they decide whether to exercise. Option sellers must perform if assigned.

On the Exam

Questions often test maximum gain and maximum loss:

• Buyers: Max loss = Premium paid (defined risk)
• Sellers: Max gain = Premium received, but potentially unlimited loss (calls) or substantial loss (puts)

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Key Takeaways

• Options give the holder the right, but not the obligation, to buy (call) or sell (put) an underlying asset
• Call buyers are bullish (want price to rise); put buyers are bearish (want price to fall)
• Option premium = Intrinsic Value + Time Value
• Intrinsic value: How much the option is in the money
• Time value: Premium above intrinsic value; decreases as expiration approaches
• Option buyers have limited risk (premium paid); option sellers have limited gain (premium received) but potentially larger losses
• "Call Up, Put Down" helps remember which direction benefits each option type