Option Contract Components

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)

Example (intrinsic value): A call has a strike price of $50. The stock trades at $53.

• Intrinsic value = $53 minus $50 = $3

Example (time value): A call has a premium of $5 and an intrinsic value of $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. This holds when other pricing factors (such as volatility or dividends) stay unchanged; the SIE tests time decay as this isolated effect. 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")
• Standard listed options are short-term contracts, generally expiring in under a year
• Long-term equity anticipation securities (LEAPS) are listed options built for a longer life: an exchange lists them with 12 months or more to expiration

Exam Tip: Gotchas

• A standard listed option is a short-lived security. When a question compares how long different securities last at issuance, a standard option is short-term, and LEAPS are the long-dated exception.

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
• A per-share gain or loss times 100 gives the dollars per contract. Breakeven is a per-share stock price, so it is never multiplied by 100

Exam Tip: Gotchas

• The 100-share multiplier turns per-share amounts into contract dollars. A premium quoted at $3 means a total cost of $300. Breakeven is a stock price, so it is never multiplied by 100.

What Should You Check on Exam Day?

• Can you state the premium formula, and calculate intrinsic value from a stock price and a strike price and time value from a premium and an intrinsic 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?
• Do you know that a standard listed option is short-term, while LEAPS are listed with 12 months or more to expiration?