1.7 Options Fundamentals
This chapter builds the vocabulary and mechanics that every later option strategy depends on: what a call and a put are, how to read a contract, how a premium splits into parts, and how trades and exercises settle. It also covers two related instruments, subscription rights and warrants, and the way index options differ from stock options. Exam questions on option math and on timing rules assume you already know these basics, and they are the terms you use when explaining an option position to a client.
What each topic covers
Calls, Puts & Expiration introduces the holder, who buys the right and pays a premium (a debit), and the writer, who takes the obligation and receives a premium (a credit). Only holders can exercise; writers are assigned. Standard options run up to nine months and expire on the third Friday at 11:59pm ET, while LEAPS last up to three years. The lesson also lists the five indexes to know: SPX, OEX, DJX, RUT and VIX.
Contract Anatomy & Moneyness breaks a quote such as Long 1 ABC Jan 40 call @ $5 into its parts. Equity options cover 100 shares, so a $5 premium costs $500. A call is in the money when the market is above the strike and a put when it is below, and holders seek in-the-money options while writers want them out of the money. Swaps close the lesson as over-the-counter contracts that suit institutions rather than retail investors.
Intrinsic Value & Time Value gives the formula premium = intrinsic value + time value. Intrinsic value is the profit from exercising now, and the remainder is time value, so an out-of-the-money option is all time value. “Call up” and “put down” help you remember the direction for each side. American-style options can be exercised at any time, which is typical for stock options, and European-style options only at expiration, which is typical for index options.
Opening, Closing & Settlement states that option trades and the stock transaction from an equity exercise both settle one business day after the trade (T+1). On Expiration Friday, trading stops at 4:00pm ET, holders have until 5:30pm ET to request exercise, and the contract expires at 11:59pm ET. The four transaction types are opening purchase, opening sale, closing sale and closing purchase, and holders close by selling while writers close by buying.
Subscription Rights & Warrants explains why a company issues rights: the pre-emptive right lets current stockholders buy new shares first, which protects them from dilution. Rights arrive one per share owned, are issued below market, carry intrinsic value, and typically expire in 60 to 90 days. Warrants are issued above market as a sweetener with another security, have mostly time value, last five years or longer, and need stockholder approval because they dilute.
Index Options & Cash Settlement covers the two ways index options differ from stock options. Most are European style, with OEX the American-style exception, and they settle in cash rather than shares, using a 100 multiplier. The worked SPX and RUT examples reuse the long call and short put formulas. The lesson also shows why investors buy index puts to hedge market risk that diversification cannot remove.