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)
| 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.