Quick Answer
An option contract has three building blocks: the strike price, the premium, and the expiration date. The strike price is fixed when the contract is created. Premium equals intrinsic value plus time value, and time value decays as expiration nears. One standard equity option contract represents 100 shares of the underlying stock.
Now that you understand calls and puts, you need to know the three building blocks of every option contract: the strike price, the premium, and the expiration date.
Strike (Exercise) Price
- The strike price is the price at which the option holder can buy (call) or sell (put) the underlying security
- Fixed at the time the contract is created; it does not change during the life of the option
- Also called the exercise price
- Strike prices are set at standard intervals (typically $1, $2.50, or $5 apart depending on the stock price)
Example: A call option with a $50 strike price gives the holder the right to buy the stock at $50, no matter what the market price is.
Premium
- The premium is the price paid by the buyer to the seller for the option contract
- This is the market price of the option itself; it fluctuates based on supply and demand
- Premium has two components:
Premium = Intrinsic Value + Time Value
Intrinsic Value
- The amount the option is in-the-money (more on this in the next section)
- For a call: market price minus strike price (if positive; otherwise $0)
- For a put: strike price minus market price (if positive; otherwise $0)
- Intrinsic value can never be negative; the minimum is $0
Time Value
- The portion of the premium above intrinsic value
- Reflects the probability that the option could become more profitable before expiration
- More time remaining = more time value = higher premium
- Time decay; time value decreases as expiration approaches
- At expiration, time value equals $0 (only intrinsic value remains)
| Component | What It Represents | Can It Be Negative? |
|---|---|---|
| Intrinsic value | Current profitability if exercised now | No (minimum $0) |
| Time value | Potential for future profitability | No (minimum $0) |
| Premium | Total cost of the option | No (minimum $0) |
Example: A call has a strike price of $50. The stock trades at $53. The premium is $5.
- Intrinsic value = $53 minus $50 = $3
- Time value = $5 minus $3 = $2
Exam Tip: Gotchas
- Time value always decreases as expiration approaches (time decay). An out-of-the-money option with only time value loses value every day, even if the stock price does not move. Sellers benefit from time decay; buyers work against it.
- Premium is NOT the same as intrinsic value. An out-of-the-money option has zero intrinsic value but can still have a premium (all time value).
Expiration Date
- The last date the option can be exercised
- After expiration, the option becomes worthless; it ceases to exist
- Standard equity options expire on the third Friday of the expiration month
- Options are described by their expiration month (e.g., "January 50 call")
Contract Size
- One standard equity option contract represents 100 shares of the underlying stock
- When you see a premium quoted at $3, the total cost is $3 x 100 = $300
- This multiplier applies to all calculations (breakeven, max gain, max loss)
Exam Tip: Gotchas
- The 100-share multiplier applies to all dollar calculations. A premium quoted at $3 means a total cost of $300. Breakeven, max gain, and max loss all use the same multiplier.
What Should You Check on Exam Day?
- Can you state the formula for premium in terms of intrinsic value and time value?
- Do you know why intrinsic value can never be negative, with a minimum of $0?
- Can you explain why time value decreases as expiration approaches, and who benefits from that decay?
- Do you know the standard contract size and how the 100-share multiplier affects total cost?
- Can you calculate intrinsic value and time value, given a stock price, a strike price, and a premium?