Stock Options Basics

This page provides an introduction to Stock Options Basics.

Overview

All options have the following three main characteristics:

• Expiration Date: All options have an expiration date after which the option will have no value.

• Strike Price: If my call option has a strike price of $$105$, I have the right to buy shares of the stock at the strike price of $$105$ using the option.

• Contract Multiplier: If an option is valued at $$5$, it can't be bought for $$5$, you will need $$500$ because options generally represent the right to trade $100$ shares of stock. The number $100$ here is called the contract multiplier.

Option Types

There are two main types of options,

Call Option

• Give the owner of call options the ability to buy $100$ shares of stock at the strike price upto expiration date.
• Call option intrinsic value $\text{abs}(\text{Stock Price} - \text{Strike Price})$.
• Each call option have extrinsic value which is associated with time left tor the expiration.

Put Option

• Give the owner of put options the ability to sell $100$ shares of stock at the strike price upto expiration date.
• Put option intrinsic value $\text{abs}(\text{Strike Price} - \text{Stock Price})$.
• Each call option have extrinsic value which is associated with time left tor the expiration.

Option Premium Value

The option premium derives its value from intrinsic and extrinsic value.

Intrinsic Value

The price of an option will always reflect the potential profit it can provide to the owner if they were to exercise the option. This price is called the intrinsic value.

Extrinsic Value

The extrinsic value of an option, also known as time value, is the portion of the option's premium that exceeds its intrinsic value.

Let's say I have a TSLA call option with a strike price of $$800$, and the current TSLA stock price is $$1000$. Because I can use the call option to make a $$200$ profit per share, the call option price must be worth $$200$ or more. If call option is priced at $$250$, then extra $$50$ is the extrinsic value or time value of the option.

There are three option types based on Intrinsic and Extrinsic value.

• In the Money: An option that has intrinsic value is called an in-the-money option.

• Out of the Money: An option with no intrinsic value and 100% extrinsic value is called an out-of-the-money option.

• At the Money: An option with a strike price very close to the current stock price is called an at-the-money option.

Shorting Option

Shorting an option means selling a contract for an option that you do not own. It is very risky, but shorting can be used to capitalize on the extrinsic (time) value of the stock.

Implied Volatility

Implied volatility represents the market's expectation of how much a stock's price will change in the future. It is derived from a stock's option prices and represents the expected "One Standard Deviation" of stock price movement over a one-year period.

In statistics, "One Standard Deviation" represents a range that encompasses approximately $68$% of the outcomes around the mean or average. Formula for calculating expected stock price after $1$ year $=$ stock price $\pm$ (stock price $*$ Implied Volatility)

info

More Buying Pressure than Selling Pressure = Increase in option prices = Higher Implied volatility
More Selling Pressure than Buying Pressure = Decrease in option price = Lower Implied Volatility

Breakeven Price

The breakeven price of an options position is the specific stock price that results in neither profit nor loss at expiration.

Call Option

The expiration breakeven price of any call option, whether you are buying or shorting, will be equal to the call option's strike price plus the trade entry price.

For example, if I am buying a call option with a strike price of $$250$ and a premium of $$10$, the breakeven price of the call option will be $$260$.

Put Option

The expiration breakeven price of any call option, whether you are buying or shorting, will be equal to the call option's strike price minus the trade entry price.

For example, if I am buying a call option with a strike price of $$250$ and a premium of $$10$, the breakeven price of the call option will be $$240$.