Module 3: Options Basics
Introduction
Welcome to the heart of this course. Everything up to now has been preparation for this moment: understanding options themselves.
Options are elegant instruments. They give you flexibility that stocks alone cannot provide. They let you profit when markets rise, fall, or stay flat. They let you generate income, protect wealth, or speculate with precision.
But before you can harness this power, you need to understand the fundamentals thoroughly. This module will teach you:
- What calls and puts actually are
- The key terminology every options trader must know
- How to read an options chain (the menu of available options)
- The basic mechanics of how options work
- An intuitive understanding of what makes options valuable
By the end, options chains won't look like confusing spreadsheets—they'll look like a menu of opportunities.
Take your time with this module. These concepts are your foundation for everything that follows.
The Two Types of Options
Every option is either a call or a put. That's it. Everything else in options trading involves combining or modifying these two building blocks.
Call Options: The Right to Buy
Definition: A call option gives the buyer the right, but not the obligation, to buy 100 shares of stock at a specified price (the strike price) on or before a specified date (the expiration date).
Think of a call option like this:
Analogy: You're looking at a house listed for $300,000, but you're not sure if you want to buy it. You give the seller $5,000 for the exclusive right to buy it at $300,000 anytime in the next 60 days. If you change your mind, you lose the $5,000 but don't have to buy the house. If the house turns out to be worth $350,000, you can still buy it for $300,000—you've locked in the price.
Who buys call options?
- Traders who think the stock will rise
- Investors who want leveraged exposure to a stock
- Anyone who wants limited risk with unlimited upside
Who sells call options?
- Traders who think the stock will stay flat or fall
- Investors who own stock and want to generate income
- Anyone willing to cap their upside in exchange for immediate income
Simple Example:
Apple stock is trading at $180.
You buy 1 Apple Call Option:
- Strike price: $185
- Expiration: 30 days from today
- Premium (cost): $3.50 per share
- Total cost: $3.50 × 100 shares = $350
This gives you the right to buy 100 shares of Apple at $185 anytime in the next 30 days.
Outcome 1: Apple rises to $200
Your option is now "in the money" (worth exercising):
- You can buy 100 shares at $185 (your locked-in price)
- Those shares are immediately worth $200
- Intrinsic value: $200 - $185 = $15 per share
- Your option is worth approximately $15 × 100 = $1,500
Your profit:
- Sold option for: $1,500
- Paid premium: $350
- Net profit: $1,150 (328% return!)
Outcome 2: Apple stays at $180
Your option expires worthless:
- Why would you pay $185 to buy stock trading at $180?
- You wouldn't exercise
- Loss: $350 (100% of premium)
Outcome 3: Apple falls to $160
Your option expires worthless:
- Even worse deal to buy at $185 when it's at $160
- Loss: $350 (the most you can lose)
Key insight: Notice that whether Apple fell to $160, $140, or even $100, your maximum loss is always $350. That's the beauty of buying options—defined risk.
Put Options: The Right to Sell
Definition: A put option gives the buyer the right, but not the obligation, to sell 100 shares of stock at a specified price (the strike price) on or before a specified date (the expiration date).
Think of a put option like this:
Analogy: You own a car worth $20,000. You're worried it might get damaged, so you buy insurance for $500 that guarantees you can "sell" it for $20,000 to the insurance company anytime this year. If nothing happens, you lose the $500 but keep your car. If the car gets totaled (now worth $5,000), you exercise your right to sell it for $20,000—your insurance pays off.
Who buys put options?
- Traders who think the stock will fall
- Investors who want portfolio protection (insurance)
- Anyone who wants defined risk while betting on decline
Who sells put options?
- Traders who think the stock will rise or stay flat
- Investors who want to buy stock at a discount
- Anyone willing to take on obligation in exchange for immediate income
Simple Example:
Tesla stock is trading at $250.
You buy 1 Tesla Put Option:
- Strike price: $240
- Expiration: 45 days from today
- Premium (cost): $6.00 per share
- Total cost: $6.00 × 100 shares = $600
This gives you the right to sell 100 shares of Tesla at $240 anytime in the next 45 days.
Outcome 1: Tesla falls to $200
Your option is now "in the money":
- You can sell 100 shares at $240 (your guaranteed price)
- Those shares are trading at $200
- Intrinsic value: $240 - $200 = $40 per share
- Your option is worth approximately $40 × 100 = $4,000
Your profit:
- Sold option for: $4,000
- Paid premium: $600
- Net profit: $3,400 (567% return!)
Outcome 2: Tesla stays at $250
Your option expires worthless:
- Why would you sell at $240 when you can sell at $250?
- You wouldn't exercise
- Loss: $600 (100% of premium)
Outcome 3: Tesla rises to $300
Your option expires worthless:
- Even worse deal to sell at $240 when it's at $300
- Loss: $600 (the most you can lose)
Key insight: Again, notice defined risk. Whether Tesla went to $300, $400, or $1,000, your maximum loss is always $600.
Calls vs. Puts: Quick Comparison
| Feature | Call Option | Put Option |
|---|---|---|
| Right to... | Buy | Sell |
| Profitable when... | Stock rises | Stock falls |
| Maximum loss (buyer) | Premium paid | Premium paid |
| Maximum gain (buyer) | Unlimited | Limited (stock can't go below $0) |
| Analogy | Reservation to buy | Insurance policy |
| Use for speculation | Bullish bet | Bearish bet |
| Use for hedging | Rare for buyers | Protecting stock you own |
Essential Options Terminology
Learning the language is critical. Here are the terms you must know:
Strike Price (Exercise Price)
Definition: The price at which the option holder can buy (call) or sell (put) the underlying stock.
Example: A call option with a $100 strike price gives you the right to buy stock at $100, regardless of the actual stock price.
Key point: Strike prices are fixed when you buy the option. They don't change.
Available strikes: Options typically have strikes in $1, $2.50, $5, or $10 increments, depending on the stock price. A $50 stock might have strikes at $45, $47.50, $50, $52.50, $55. A $500 stock might have strikes at $480, $490, $500, $510, $520.
Premium
Definition: The price you pay to buy an option or receive when you sell an option.
Example: If a call option is quoted at $4.50, you pay $4.50 × 100 shares = $450 for one contract.
Important: Premium is always quoted per share, but since one contract represents 100 shares, you multiply by 100 to get the actual cost.
What determines premium?
- Intrinsic value (how far in-the-money)
- Time until expiration
- Stock volatility
- Interest rates
- Dividends
We'll explore pricing deeply in Module 5.
Expiration Date
Definition: The date when the option contract expires and becomes worthless if not exercised or sold.
Standard expirations:
- Weekly options: Expire every Friday
- Monthly options: Expire the third Friday of each month
- Quarterly options: Expire the end of March, June, September, December
- LEAPS (Long-term): Expire in January, up to 3 years out
Example: An option with "Nov 15, 2024" expiration expires at market close on November 15, 2024.
Critical point: Options are wasting assets. Every day that passes, they lose some value (all else being equal). On expiration day, any out-of-the-money option becomes completely worthless.
In-the-Money (ITM)
Definition: An option that would have intrinsic value if exercised right now.
For calls: Stock price is above the strike price
- Stock at $105, call strike $100 → $5 in-the-money
For puts: Stock price is below the strike price
- Stock at $95, put strike $100 → $5 in-the-money
Why it matters: ITM options have real, tangible value. They're more expensive but safer.
At-the-Money (ATM)
Definition: An option whose strike price is at or very near the current stock price.
Example: Stock trading at $100, option strike at $100 → at-the-money
Why it matters: ATM options have maximum time value and are most sensitive to price movement. They're often the most liquid (easiest to trade).
Out-of-the-Money (OTM)
Definition: An option that would have no intrinsic value if exercised right now.
For calls: Stock price is below the strike price
- Stock at $95, call strike $100 → $5 out-of-the-money
For puts: Stock price is above the strike price
- Stock at $105, put strike $100 → $5 out-of-the-money
Why it matters: OTM options are cheaper but riskier. They can expire worthless even if you're directionally correct but the stock doesn't move far enough.
Intrinsic Value
Definition: The amount of value an option has if exercised immediately. The real, tangible value.
For calls: Stock price - Strike price (if positive) For puts: Strike price - Stock price (if positive)
Examples:
- Stock at $110, call strike $100 → Intrinsic value = $10
- Stock at $90, put strike $100 → Intrinsic value = $10
- Stock at $95, call strike $100 → Intrinsic value = $0 (can't be negative)
Key point: OTM options have zero intrinsic value. All their value is time value.
Extrinsic Value (Time Value)
Definition: The portion of an option's premium beyond its intrinsic value. This represents the possibility that the option could become more valuable before expiration.
Formula:
Extrinsic Value = Option Premium - Intrinsic Value
Example:
Stock at $105 Call strike $100 Option premium $8
- Intrinsic value: $105 - $100 = $5
- Extrinsic value: $8 - $5 = $3
That $3 represents:
- Time until expiration (more time = more extrinsic value)
- Volatility (more movement expected = more extrinsic value)
- Probability the stock moves even higher
Key insight: Extrinsic value decays to zero by expiration. This is called time decay, and it accelerates as expiration approaches.
The Option Contract
Contract specifications:
- 1 contract = 100 shares (standard for equity options)
- Contract symbol: A unique code identifying the option
- Multiplier: Always 100 for standard equity options
Why 100 shares? Historical convention. Options were designed to correspond to typical stock trading lots of 100 shares (called a "round lot").
Example:
You buy 5 call option contracts:
- You control 5 × 100 = 500 shares worth of stock exposure
- If the premium is $4.00 per share, you pay 5 × $4.00 × 100 = $2,000
American vs. European Options
American options:
- Can be exercised anytime before expiration
- Most stock options in the U.S. are American-style
- More flexibility for the buyer
European options:
- Can be exercised only at expiration
- Common for index options (like SPX)
- Slightly different pricing
As a beginner: You'll mostly trade American options on stocks. Just know that some index options are European-style, meaning you can't exercise them early.
Understanding Moneyness: A Visual Guide
Let's visualize the relationship between stock price and option value.
For Call Options
Stock Price →
OTM | ATM | ITM
───────────────────┼───────┼───────────────────
85 90 95 100
Strike: $90
If stock is at $85: Call is OTM (out-of-the-money), pure time value
If stock is at $90: Call is ATM (at-the-money), maximum time value
If stock is at $95: Call is ITM (in-the-money), $5 intrinsic + time value
If stock is at $100: Call is deep ITM, $10 intrinsic + small time value
As stock price increases:
- Calls become more valuable
- More intrinsic value
- Less time value (as percentage)
For Put Options
Stock Price →
ITM | ATM | OTM
───────────────────┼───────┼───────────────────
85 90 95 100
Strike: $90
If stock is at $85: Put is ITM (in-the-money), $5 intrinsic + time value
If stock is at $90: Put is ATM (at-the-money), maximum time value
If stock is at $95: Put is OTM (out-of-the-money), pure time value
If stock is at $100: Put is deep OTM, almost worthless
As stock price decreases:
- Puts become more valuable
- More intrinsic value
- Less time value (as percentage)
Reading an Options Chain
An options chain is like a menu showing all available options for a stock. Learning to read it is essential.
Sample Options Chain for XYZ Stock (Trading at $100)
Calls (Right to Buy)
| Expiration | Strike | Bid | Ask | Last | Volume | Open Interest | Implied Vol |
|---|---|---|---|---|---|---|---|
| Nov 15 | $95 | $7.20 | $7.40 | $7.30 | 250 | 1,200 | 28% |
| Nov 15 | $100 | $3.80 | $4.00 | $3.90 | 850 | 3,400 | 30% |
| Nov 15 | $105 | $1.50 | $1.65 | $1.60 | 420 | 1,800 | 32% |
Puts (Right to Sell)
| Expiration | Strike | Bid | Ask | Last | Volume | Open Interest | Implied Vol |
|---|---|---|---|---|---|---|---|
| Nov 15 | $95 | $1.40 | $1.55 | $1.50 | 180 | 900 | 31% |
| Nov 15 | $100 | $3.70 | $3.90 | $3.80 | 920 | 3,600 | 30% |
| Nov 15 | $105 | $7.10 | $7.30 | $7.20 | 310 | 1,100 | 29% |
Understanding Each Column
Expiration: The date the option expires. Options with the same expiration date are grouped together. You'll often see multiple expiration dates available (weekly, monthly, quarterly).
Strike: The price at which you can buy (call) or sell (put) the stock.
Bid: The highest price a buyer is willing to pay RIGHT NOW. This is what you'll receive if you SELL to open an option.
Ask: The lowest price a seller is willing to accept RIGHT NOW. This is what you'll pay if you BUY to open an option.
Bid-Ask Spread: The difference between bid and ask. Narrower spreads = more liquid (better). Wide spreads = less liquid (be careful).
Example: $3.80 bid / $4.00 ask = $0.20 spread
Last: The last price at which this option traded. Can be misleading if it was hours ago and the stock has moved.
Volume: Number of contracts traded TODAY. Higher volume = more liquidity = easier to enter/exit = better for retail traders.
Open Interest: Total number of outstanding option contracts. This represents total market positions. Higher open interest = more liquidity.
Implied Volatility (IV): Market's expectation of how much the stock will move. Higher IV = more expensive options. We'll cover this extensively in Module 5.
How to Use an Options Chain
Step 1: Choose your expiration
Ask yourself: How long do I need to be right?
- Very confident in short-term move → Weekly options
- Moderately confident → 30-45 days out
- Longer-term view → 2-3 months or LEAPS
Step 2: Choose your strike
Ask yourself: What price movement am I expecting?
- Conservative (high probability) → ITM options
- Moderate (balanced) → ATM options
- Aggressive (low probability, high reward) → OTM options
Step 3: Check liquidity
Look at volume and open interest:
- Volume over 100 → Generally okay
- Volume over 500 → Good liquidity
- Open interest over 1,000 → Excellent liquidity
Also check the bid-ask spread:
- Spread under 10% of option price → Acceptable
- Spread under 5% → Good
- Spread under 2% → Excellent
Step 4: Note the implied volatility
Compare IV across strikes and expirations:
- High IV = Expensive options (might avoid buying)
- Low IV = Cheap options (good for buying)
- We'll cover this more in Module 5
Step 5: Calculate your costs
Remember to multiply by 100:
- $3.90 ask × 100 shares = $390 per contract
- Want 3 contracts? $390 × 3 = $1,170 total
Practical Example: Reading a Real Chain
Scenario: You're bullish on XYZ (currently at $100) and expect it to reach $108 within 3 weeks.
Option 1: $105 Strike Call, Nov 15 Expiration
- Ask price: $1.65
- Cost: $165 per contract
- Breakeven: $105 + $1.65 = $106.65
- If stock hits $108: Profit = ($108 - $105 - $1.65) × 100 = $135 per contract (82% return)
- If stock stays at $100: Loss = $165 (100% of investment)
Option 2: $100 Strike Call, Nov 15 Expiration
- Ask price: $4.00
- Cost: $400 per contract
- Breakeven: $100 + $4.00 = $104.00
- If stock hits $108: Profit = ($108 - $100 - $4.00) × 100 = $400 per contract (100% return)
- If stock stays at $100: Loss = approximately $200 (only time value lost; still has $0 intrinsic value at expiration)
Option 3: $95 Strike Call, Nov 15 Expiration
- Ask price: $7.40
- Cost: $740 per contract
- Breakeven: $95 + $7.40 = $102.40
- If stock hits $108: Profit = ($108 - $95 - $7.40) × 100 = $560 per contract (76% return)
- If stock stays at $100: Loss = approximately $240 (loses time value; retains $5 intrinsic value)
Analysis:
Most aggressive: $105 strike (highest % return, but highest risk of total loss) Balanced: $100 strike (moderate cost, moderate risk) Conservative: $95 strike (already ITM, lower % return but safer)
Your choice depends on:
- Your confidence level
- Risk tolerance
- Capital available
- Desired risk/reward profile
How Options Are Exercised and Assigned
Exercise (Buyer's Action)
When you own an option, you can exercise it, which means:
- Call: You buy 100 shares at the strike price
- Put: You sell 100 shares at the strike price
In practice: Most traders never exercise options. Instead, they sell the option itself to close the position. This is usually more profitable because you capture remaining time value.
When to exercise:
- Deep in-the-money at expiration
- Need the actual shares (rare)
- About to pay a dividend and you want to capture it
Example:
You own a call option:
- Strike: $100
- Stock now at $110
- Option trading at $10.50
If you exercise:
- You pay $10,000 to buy 100 shares
- Shares immediately worth $11,000
- Gain: $1,000 (minus the premium you originally paid)
If you sell the option:
- You receive $10.50 × 100 = $1,050
- You keep the extra $50 of time value
- Generally better!
Assignment (Seller's Obligation)
When you sell an option, you can be assigned, which means:
- Call: You must sell 100 shares at the strike price
- Put: You must buy 100 shares at the strike price
Assignment is random among all short option holders with the same contract. The Options Clearing Corporation (OCC) handles this automatically.
When assignment happens:
- Usually at or near expiration for ITM options
- Can happen anytime for American-style options (but rare before expiration)
- Automatically at expiration if option is >$0.01 ITM
Example:
You sold a put option:
- Strike: $100
- Premium received: $3.00
- Stock falls to $90 at expiration
You will be assigned:
- You must buy 100 shares at $100
- Market value is $90 per share
- You effectively paid $100 - $3 (premium) = $97 per share
- Shares worth $90, so you have an unrealized loss of $7 per share ($700 total)
- But you now own the shares and can hold or sell them
The Four Basic Option Positions
Every options trade falls into one of four categories:
1. Buy a Call (Long Call)
Market view: Bullish (stock will rise)
Maximum risk: Premium paid Maximum reward: Unlimited (stock can rise indefinitely) Breakeven: Strike price + premium paid
When to use: You believe the stock will rise significantly
Example:
- Buy call, strike $50, premium $2
- Maximum loss: $200
- Breakeven: $52
- If stock reaches $60: Profit = ($60 - $50 - $2) × 100 = $800
2. Sell a Call (Short Call)
Market view: Bearish or neutral (stock won't rise above strike)
Maximum risk: Unlimited (if stock soars) Maximum reward: Premium received Breakeven: Strike price + premium received
When to use: You believe the stock will stay flat or decline (or you own the stock—covered call)
Warning: Naked short calls are very risky. Most beginners should only sell calls if they own the underlying stock.
Example:
- Sell call, strike $50, premium $2
- Maximum gain: $200
- Breakeven: $52
- If stock reaches $60: Loss = ($60 - $50 - $2) × 100 = $800 (or unlimited if stock continues rising)
3. Buy a Put (Long Put)
Market view: Bearish (stock will fall)
Maximum risk: Premium paid Maximum reward: Large (stock can fall to zero) Breakeven: Strike price - premium paid
When to use: You believe the stock will decline, or you want portfolio insurance
Example:
- Buy put, strike $50, premium $2
- Maximum loss: $200
- Breakeven: $48
- If stock falls to $40: Profit = ($50 - $40 - $2) × 100 = $800
4. Sell a Put (Short Put)
Market view: Bullish or neutral (stock won't fall below strike)
Maximum risk: Large (strike price minus premium, if stock goes to zero) Maximum reward: Premium received Breakeven: Strike price - premium received
When to use: You believe the stock will stay flat or rise (or you want to buy stock at a discount)
Example:
- Sell put, strike $50, premium $2
- Maximum gain: $200
- Maximum loss: ($50 - $2) × 100 = $4,800 (if stock goes to zero)
- Breakeven: $48
- If stock stays above $50: You keep $200, option expires worthless
Options Pricing: Intuitive Understanding
Before we get into formulas (that's Module 5), let's develop intuition for what makes options valuable.
The Six Factors Affecting Option Prices
1. Stock Price
The most obvious factor:
- As stock rises → Calls become more valuable, puts become less valuable
- As stock falls → Puts become more valuable, calls become less valuable
2. Strike Price
The option's strike relative to the stock price:
- Calls: Lower strikes are more expensive (deeper ITM)
- Puts: Higher strikes are more expensive (deeper ITM)
3. Time Until Expiration
More time = more value:
- Longer-dated options are always more expensive
- More time means more chances for the stock to move in your favor
- Time value decays, and decay accelerates near expiration
Think of it like insurance: A 1-year car insurance policy costs more than a 1-month policy because there's more time for an accident to occur.
4. Volatility
How much the stock moves:
- High volatility → More expensive options (both calls and puts)
- Low volatility → Cheaper options
Why? More movement means more chance the option will become profitable.
Example: Would you pay more for an option on a stable utility stock that moves 1% per day, or a volatile tech stock that moves 5% per day? The tech stock option is worth more because there's higher probability of profit.
5. Interest Rates
Small effect for most retail traders:
- Higher rates → Calls slightly more expensive, puts slightly less expensive
- This is because of the time value of money
- Usually negligible unless rates are very high
6. Dividends
Affects options on dividend-paying stocks:
- Expected dividends make calls cheaper and puts more expensive
- Why? When stock pays a dividend, the stock price drops by the dividend amount on the ex-dividend date
The Relationship: Intrinsic Value + Extrinsic Value
Remember this fundamental equation:
Option Premium = Intrinsic Value + Extrinsic Value
At purchase:
- OTM options are 100% extrinsic value
- ATM options are 100% extrinsic value
- ITM options are partially intrinsic, partially extrinsic
As expiration approaches:
- Extrinsic value decays toward zero
- Intrinsic value remains (if option is ITM)
- At expiration, option is worth only intrinsic value
Example:
Stock at $105 Call strike $100 45 days to expiration Option premium $8
- Intrinsic value: $5
- Extrinsic value: $3
15 days later, stock still at $105:
- Intrinsic value: Still $5 (unchanged)
- Extrinsic value: Maybe $2 (decayed from $3)
- Option premium: $7 (down from $8)
At expiration, stock still at $105:
- Intrinsic value: Still $5
- Extrinsic value: $0 (all gone)
- Option premium: $5
This is time decay in action.
Put-Call Parity: An Important Relationship
Here's a fascinating relationship between calls and puts:
For European options with the same strike and expiration:
Call Price - Put Price = Stock Price - Strike Price (adjusted for interest and dividends)
What this means: The relative prices of calls and puts are locked in a mathematical relationship. If one becomes mispriced, arbitrageurs will quickly correct it.
Practical implication: You can't have a call and put on the same stock, same strike, same expiration with wildly different pricing. The market keeps them in balance.
Example:
Stock at $100 Strike at $100
If the call is trading at $5 and the put at $4.50, the $0.50 difference reflects interest rates and dividends. You can't have a situation where the call is $10 and the put is $1 with everything else the same—arbitrageurs would exploit this instantly.
Common Beginner Mistakes with Options Basics
Let's address mistakes now, before you make them:
Mistake 1: Confusing the right to buy with the obligation to buy
Reality: Buying an option gives you a choice, not an obligation. You're never forced to exercise.
Mistake 2: Not multiplying by 100
Options are quoted per share but represent 100 shares.
- If an option is quoted at $3.50, you pay $350, not $3.50
- Easy mistake with big consequences!
Mistake 3: Buying OTM options that are too far away
Example: Stock at $100, buying $130 calls because they're only $0.50
Reality: Cheap options are cheap for a reason—low probability of profit. The stock needs to move 30%+ for you to break even. Stick closer to the money when starting out.
Mistake 4: Ignoring liquidity
Buying options with low volume or wide bid-ask spreads:
- Hard to exit your position
- Pay huge spreads entering and exiting
- May not be able to sell when you want
Rule of thumb: Look for volume >100 and bid-ask spread <10% of option price.
Mistake 5: Holding options until expiration
Time decay accelerates near expiration:
- Most profitable traders exit positions with 2-4 weeks remaining
- Capture most of the gain while avoiding extreme time decay
- Reinvest capital in new positions
Mistake 6: Not understanding which options are American vs. European
Most stock options are American (can exercise anytime), but some index options are European (can only exercise at expiration). Know which type you're trading.
Mistake 7: Focusing only on the option price, not the breakeven
An option might seem cheap, but check your breakeven:
- Stock at $100, buy $105 call for $2
- You need stock to reach $107 just to break even
- That's a 7% move—is that realistic in your timeframe?
Key Takeaways
Before moving to Module 4, ensure you understand:
✓ Call options give you the right to buy; put options give you the right to sell
✓ One option contract = 100 shares of the underlying stock
✓ Options premiums are quoted per share but cost premium × 100
✓ In-the-money options have intrinsic value; out-of-the-money options have only time value
✓ Option value = Intrinsic value + Extrinsic value (time value)
✓ Options chains show all available options with their bid, ask, volume, and other key data
✓ Liquidity matters—check volume, open interest, and bid-ask spread before trading
✓ Four basic positions: long call (bullish), short call (bearish/neutral), long put (bearish), short put (bullish/neutral)
✓ Time decay erodes option value, especially near expiration
✓ Maximum loss for option buyers is always the premium paid—this is defined risk
Self-Check Questions
Test your understanding:
-
If you buy a call option and the stock goes down, what's the maximum you can lose?
Click to reveal answer
The maximum you can lose is the premium you paid for the option. Even if the stock goes to zero, you can't lose more than your initial investment.
-
A stock is trading at $50. Which put option is in-the-money: the $45 strike or the $55 strike?
Click to reveal answer
The $55 strike put is in-the-money. For puts, ITM means the strike is above the stock price. You have the right to sell at $55 when the stock is at $50—that has $5 of intrinsic value.
-
An option is quoted at $3.25. How much do you actually pay for one contract?
Click to reveal answer
You pay $3.25 × 100 = $325 per contract. Options are quoted per share but control 100 shares.
-
A call option has intrinsic value of $6 and is trading for $9. What is its extrinsic value?
Click to reveal answer
Extrinsic value = Premium - Intrinsic value = $9 - $6 = $3. This $3 represents time value and the possibility the option could become more valuable before expiration.
-
True or False: If you buy a put option, you're obligated to sell the stock at the strike price.
Click to reveal answer
False. Buying an option gives you the RIGHT, not the obligation. You can choose whether to exercise. Only option sellers have obligations.
Practice Exercise: Options Chain Analysis
Study this options chain and answer the questions:
Stock: ABC Corporation, Currently Trading at $155
Calls (Dec 20 Expiration - 30 days away)
| Strike | Bid | Ask | Volume | Open Interest |
|---|---|---|---|---|
| $145 | $12.80 | $13.20 | 45 | 890 |
| $150 | $8.50 | $8.90 | 210 | 2,340 |
| $155 | $5.20 | $5.50 | 680 | 4,120 |
| $160 | $2.80 | $3.10 | 420 | 2,890 |
| $165 | $1.10 | $1.35 | 180 | 1,120 |
Puts (Dec 20 Expiration - 30 days away)
| Strike | Bid | Ask | Volume | Open Interest |
|---|---|---|---|---|
| $145 | $0.85 | $1.05 | 120 | 980 |
| $150 | $2.60 | $2.85 | 290 | 2,670 |
| $155 | $5.10 | $5.40 | 720 | 4,380 |
| $160 | $8.80 | $9.20 | 380 | 2,450 |
| $165 | $13.10 | $13.60 | 95 | 1,230 |
Questions:
- Which call strike is approximately at-the-money?
- What would it cost to buy 3 contracts of the $160 strike call?
- Which option has the best liquidity?
- If you're bullish and want a high probability trade, which call strike should you choose?
- Calculate the intrinsic and extrinsic value of the $150 call option.
- What's the bid-ask spread percentage for the $165 call?
- If you expect the stock to drop to $145, which put strike offers the best risk/reward?
Solutions:
Click to reveal detailed solutions
1. Which call strike is approximately at-the-money?
The $155 strike is at-the-money since the stock is trading at $155.
2. What would it cost to buy 3 contracts of the $160 strike call?
Ask price: $3.10 Cost per contract: $3.10 × 100 = $310 3 contracts: $310 × 3 = $930
3. Which option has the best liquidity?
The $155 call has the best liquidity with 680 volume and 4,120 open interest. Both are significantly higher than other strikes. The $155 put also has excellent liquidity (720 volume, 4,380 open interest).
4. If you're bullish and want a high probability trade, which call strike should you choose?
The $150 call (already in-the-money) or the $155 call (at-the-money). These have the highest probability of profit.
The $150 strike is more conservative:
- Already has $5 intrinsic value
- Stock only needs to move slightly higher to be profitable
- More expensive ($8.50-$8.90) but safer
The $155 strike is balanced:
- At-the-money with maximum liquidity
- Less expensive ($5.20-$5.50)
- Needs stock to rise to $160.50 to break even
5. Calculate the intrinsic and extrinsic value of the $150 call option.
Stock price: $155 Strike price: $150 Option trading at (midpoint): $8.70
Intrinsic value = Stock price - Strike price = $155 - $150 = $5.00 Extrinsic value = Option premium - Intrinsic value = $8.70 - $5.00 = $3.70
The $3.70 represents time value—the market is pricing in the possibility of the stock moving higher over the next 30 days.
6. What's the bid-ask spread percentage for the $165 call?
Bid: $1.10 Ask: $1.35 Spread: $1.35 - $1.10 = $0.25 Midpoint: ($1.10 + $1.35) / 2 = $1.225
Spread percentage = $0.25 / $1.225 = 20.4%
This is a very wide spread! This option has poor liquidity (only 180 volume). You'd pay a significant cost entering and exiting. Better to stick with the more liquid $155 or $160 strikes.
7. If you expect the stock to drop to $145, which put strike offers the best risk/reward?
Let's analyze each:
$150 Put (slightly ITM):
- Cost: $2.85 (ask)
- If stock hits $145: Intrinsic value = $150 - $145 = $5.00
- Profit: $5.00 - $2.85 = $2.15 per share = $215 per contract
- Return: 75%
$155 Put (ATM):
- Cost: $5.40 (ask)
- If stock hits $145: Intrinsic value = $155 - $145 = $10.00
- Profit: $10.00 - $5.40 = $4.60 per share = $460 per contract
- Return: 85%
$160 Put (OTM):
- Cost: $9.20 (ask)
- If stock hits $145: Intrinsic value = $160 - $145 = $15.00
- Profit: $15.00 - $9.20 = $5.80 per share = $580 per contract
- Return: 63%
Best choice: $155 Put
- Highest percentage return
- Good liquidity
- Balanced risk/reward
- Already at-the-money, so needs less movement than $150 put to be profitable
The $160 put has higher absolute profit but lower percentage return and requires more capital. The $155 put is the sweet spot.
What's Next?
Congratulations! You now understand the fundamentals of options. You know what calls and puts are, how to read an options chain, and the basic terminology every trader must know.
You can now look at an options chain and understand what you're seeing. You know the difference between intrinsic and extrinsic value. You understand that options are wasting assets that decay over time.
Most importantly, you understand that buying options provides defined risk—you can never lose more than the premium you pay.
In Module 4: Basic Options Strategies, we'll put this knowledge to work. You'll learn specific strategies for different market conditions: bullish, bearish, and neutral. We'll cover covered calls for income, protective puts for insurance, and simple directional plays with calls and puts.
You're building real trading skills now. Take pride in how far you've come.
Ready to continue? Proceed to Module 4: Basic Options Strategies