Options Contracts and Pricing
Core concepts
An option gives the buyer a right, not an obligation, to buy (call) or sell (put) at a strike price before or on expiry. Distinguish European (exercise at expiry only) from American (any time before expiry) exercise. Know moneyness: in-the-money, at-the-money, out-of-the-money, and intrinsic versus time value. Premium = intrinsic value + time value.
Understand the drivers of option price: underlying price, strike, time to expiry, volatility, interest rates, and dividends. Learn the Greeks: delta (sensitivity to underlying), gamma (change in delta), theta (time decay), vega (volatility sensitivity), and rho (rate sensitivity). Know put-call parity for European options: C − P = S − K × e^(−rT), and the payoff diagrams for long/short calls and puts.
Traps
Questions often confuse buyer and seller obligations: the buyer pays premium and has limited loss; the writer receives premium and has potentially unlimited loss on calls. Another trap is intrinsic value for a put: max(K − S, 0), not max(S − K, 0). Watch for 'time value is always positive' - it is zero at expiry and can be negative only in odd market conditions; typically it decays to zero.
Worked example
A call has strike 50, underlying 56, premium 8. Intrinsic = 6, time value = 2. At expiry with S = 56, payoff = 6 and profit = 6 − 8 = −2. Break-even at expiry = strike + premium = 58.
Rule of thumb
Long call break-even = strike + premium; long put break-even = strike − premium. Maximum loss for a long option is the premium paid.