Vocabulary
Option Premium: price of an option
Call Option: gives holder the right to buy the underlying asset at the strike price
Put Option: gives the holder the right to sell the underlying asset at the strike price
Strike price: exercise or striking price
Option Characteristics
Strike prices:
Multiples of $2.50 for stocks trading for $25 or below
Multiples of $5.00 for stocks trading for more than $25
$10.00 multiples for very high priced stocks
Options contracts are to buy and sell blocks of 100 shares of a stock
Option Premia (Prices)
The price of an option is called a premium to distinguish it from the exercise or strike price at which the underlying asset can be bought (with a call option) or sold (with a put option)
Call Option Premia
A Call option is an option to buy
Intrinsic value of a call = (current) stock price - strike price
Option premium = Intrinsic value + time value
If intrinsic value = zero, the option is “out-of-the-money,” “near-the-money,” or “at-the-money”
In/Out/At-the-Money Call Options
In-the-money: the option has intrinsic value because the stock price is greater than the strike price.  This option gives you the right to buy something for less than the market price
Out-of-the-money: the option has no intrinsic value because the stock price is less than the strike price.  It may still have time value
At-the-money: the option has no intrinsic value because the stock price is currently equal to the strike price.   It may still have time value, and generally does.
Call Option Premia
Intrinsic value can be zero, but cannot be negative (by convention)
If the strike price were greater than the market price of the stock, no one would exercise the option, they would just buy the stock, and the option would expire worthless
Time value = option premium – intrinsic value

Time Value
Time value declines
a.  as the option approaches its expiration date
b.  as the current market price approaches the strike price
Time Value
Conversely, time value increases
a.  the farther the option is from its expiration date
b.  the greater the amount the current market price exceeds the strike price (for a call option)
Put Option Premia
A Put is an option to sell
Intrinsic value = strike price – (current) stock price
Option premium = Intrinsic value + time value
If intrinsic value = zero, the option is “out-of-the-money,” “near-the-money,” or “at-the-money”
Put Option Premia
Intrinsic value can be zero, but cannot be negative (by convention)
If the strike price were less than the market price of the stock, no one would exercise the option, they would just sell the stock, and the option would expire worthless
Time value = option premium – intrinsic value
In/Out/At-the-Money Put Options
In-the-money: the put has intrinsic value because the stock price is less than the strike price.  This option gives you the right to sell something for more than the market price
Out-of-the-money: the put has no intrinsic value because the stock price is greater than the strike price.  It may still have time value
At-the-money: the put has no intrinsic value because the stock price is currently equal to the strike price.   It may still have time value, and generally does

Option Listings
Online options listings for Cisco Systems
http://quote.cboe.com/QuoteTable.asp?Ticker=CSCO
Specify company, expiration date, strike price, and type of option (call or put)
Call premia
Each call has
a.  an intrinsic value = current price – strike price (= zero if negative)
b.  a time value = premium – intrinsic value

Put premia
Each put has
a.  an intrinsic value = strike price - current price (= zero if negative)
b.  a time value = premium – intrinsic value
 

Profit & loss diagrams
Invented by Louis Bachelier
Plot profit (+) or loss (-) on vertical (y) axis
As a function of the stock price on the expiration day
Long: buy options (increase your position)
Short: sell options (shorten your position)
 
 

The Black-Scholes Model
Call premium = f(K,T,S,V,D,r)
w/ signs of first derivatives:
K (-) option striking price
T (+) time to expiration
S (+) current stock price
V (+) stock volatility
D (-) stock dividend yield
R (+) current risk-free interest rate (30 day t-bill)
The Black-Scholes Model
C = S[N(d1)] – Ke-rt[N(d2)]
Where:
d1 = [ln(S/K) + [r + (?2/2)]t]/??t
d2 = d1 - ??t

American & European Options
American options can be exercised any time up to the expiration date
European options can only be exercised during a specified period before the expiration date
A capped option is automatically exercised if the stock hits the cap price prior to expiration and can also be exercised like a European option if it has not already hit the cap price