# Option Theory Basics

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3 There are several other important terms in an option contract: A long position is defined as any position which will theoretically increase in value should the price of the underlying security increase. Vice versa, the position will theoretically decrease in value should the underlying security decrease. The buying of stock, the buying of a call, or the sale of a put all constitute a long position. 3

4 A short position is defined as any position which will theoretically increase in value should the price of the underlying security decrease. Vice versa, the position will theoretically decrease in value should the underlying security increase. The selling of stock, the selling of a call, or the buying of a put all constitute a short position. 4

5 An option can be described by its strike price s proximity to the stock s price. An option can either be in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM). An at-the-money option is described as an option whose exercise or strike price is approximately equal to the present price of the underlying stock. For instance, if Microsoft (MSFT) is trading at \$65.00, then the January \$65.00 call would be an example of an at-the-money call option. Similarly, the January \$65.00 put would be an example of an at-the-money put option. Please view charts below for at-the-money option examples. MSFT CALLS Stock = \$65.00 Strike Price Option Price Status Intrinsic Extrinsic ITM ITM ITM OTM OTM OTM 0.15 MSFT PUTS Stock = \$65.00 Strike Price Option Price Status Intrinsic Extrinsic OTM OTM OTM ITM ITM ITM

6 An in-the-money call option is described as a call whose strike (exercise) price is lower than the present price of the underlying. An in-the-money put has a strike (exercise) price higher than the present price of the underlying, i.e. an option which could be exercised immediately for a cash credit should the option buyer wish to exercise the option. In our Microsoft example above, an in-the-money call option would be any listed call option with a strike price below \$65.00 (the price of the stock). So, the MSFT January 60 call option would be an example of an in-the-money call. The reason is that at any time prior to the expiration date, you could exercise the option and profit from the difference in value: in this case \$5.00 (\$65.00 stock price - \$60.00 call option strike price = \$5.00 of intrinsic value). In other words, the option is \$5.00 in-the-money. Using our Microsoft example, an in-the-money put option would be any listed put option with a strike price above \$65.00 (the price of the stock). The reason is that at any time prior to the expiration date, you could exercise the option and profit from the difference in value: in this case \$5.00 (\$70.00 put option strike price - \$65.00 stock price = \$5.00 of intrinsic value.) In other words, the option is \$5.00 in-the-money. Please view charts below for more in-the-money option examples. MSFT CALLS Stock =\$ Strike Price Option Price Status Intrinsic Extrinsic ITM ITM ITM OTM OTM OTM 0.15 MSFT PUTS Stock = \$65.00 Strike Price Option Price Status Intrinsic Extrinsic OTM OTM OTM ITM ITM ITM

7 An out-of-the-money call is described as a call whose exercise price (strike price) is higher than the present price of the underlying stock. Thus, an out-of-the-money call option s entire premium consists of only extrinsic value. There is no intrinsic value in an out-of-the-money call because the option s strike price is higher than the current stock price. For example, if you chose to exercise the MSFT January 70 call while the stock was trading at \$65.00, you would essentially be choosing to buy the stock for \$70.00 when the stock is trading at \$65.00 on the open market. This action would result in a \$5.00 loss. Obviously, you would not want to do that. An out-of-the-money put has an exercise price that is lower than the present price of the underlying. Thus, an out-of-the-money put option s entire premium consists of only extrinsic value. There is no intrinsic value in an out-of-the-money put because the option s strike price is lower than the current stock price. For example, if you chose to exercise the MSFT January 60 put while the stock was trading at\$65.00, you would be choosing to sell the stock at \$60.00 when the stock is trading at \$65.00 in the open market. This action would result in a \$5.00 loss. Obviously, you would not want to do that. Please view charts below for out-of-the-money option examples. MSFT CALLS Stock = \$65.00 Strike Price Option Price Status Intrinsic Extrinsic ITM ITM ITM OTM OTM OTM 0.15 MSFT PUTS Stock = \$65.00 Strike Price Option Price Status Intrinsic Extrinsic OTM OTM OTM ITM ITM ITM

8 Premium is the total amount of money (price) you pay for an option. So, if the Microsoft (MSFT) May 65 calls cost you \$1.50 then the \$1.50 is the amount of the premium of the option. The total price of an option (premium) consists of two components. Those two components are intrinsic value and extrinsic value. Please view charts below for option price (premium) examples. MSFT CALLS Stock = \$ Strike Price Option Price Status Intrinsic Extrinsic ITM ITM ITM OTM OTM OTM 0.15 MSFT PUTS Stock = \$65.00 Strike Price Option Price Status Intrinsic Extrinsic OTM OTM OTM ITM ITM ITM

9 Intrinsic value, also called parity, is the amount by which an option is in the money. In the case of a call, the intrinsic value is equal to the present stock price minus the strike price. In the case of a put, the intrinsic value is equal to the strike price minus the present stock price. Only in-the-money options have intrinsic value. Out-of-themoney options have no intrinsic value. For example, with MSFT trading at \$65.00, the MSFT January 60 calls will have \$5.00 of intrinsic value. So, if the MSFT January 60 calls were trading at \$5.70, then \$5.00 of that premium would be intrinsic value. At the same time, the MSFT January 70 put will also have \$5.00 of intrinsic value. So, if the MSFT January 70 puts were trading for \$5.70, then \$5.00 of that premium would be intrinsic value. Please view charts below for intrinsic value examples. MSFT CALLS Stock =\$ Strike Price Option Price Status Intrinsic Extrinsic ITM ITM ITM OTM OTM OTM 0.15 MSFT PUTS Stock = \$65.00 Strike Price Option Price Status Intrinsic Extrinsic OTM OTM OTM ITM ITM ITM

10 Extrinsic value is defined as the price of an option less its intrinsic value. In the case of out-of-the-money options, the option s entire price consists only of extrinsic value. Extrinsic value is influenced by several factors, with the largest being volatility. In the examples above, if the MSFT January 60 calls were trading at \$5.70 and \$5.00 of that was intrinsic value, then the remainder (\$.70) is extrinsic value. The same also holds true for the January 70 puts. If they were trading at \$5.70 and \$5.00 of that was intrinsic value, then the rest (\$.70) is extrinsic value. Please view charts below for extrinsic value examples. MSFT CALLS Stock =\$ Strike Price Option Price Status Intrinsic Extrinsic ITM ITM ITM OTM OTM OTM 0.15 MSFT PUTS Stock = \$65.00 Strike Price Option Price Status Intrinsic Extrinsic OTM OTM OTM ITM ITM ITM

11 The term time decay is defined as the rate by which an options extrinsic value decays over the life of the contract. This concept can be illustrated by the charts below. 11

14 Also notice the difference in the profit potential between a purchase of the option as opposed to a sale of the option. Lastly, it is important to note the unlimited potential risk inherent in the sale of an option, compared to the fixed risk of an option purchase. Please note the call parity graphs below. A put option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right but not the obligation to sell a specified stock or other underlying instrument at a specified price by a specified date. 14

16 Please see the put parity graphs below. The definitions and concepts contained in the previous section are the building blocks of the option strategies we will discuss. It is of vital importance for you to go through these concepts and definitions several times to gain a clear understanding of them. 16

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