Learn strike price, premium, expiry

Core Concept

Every option contract has three fundamental parameters that define its terms: the strike price (the price at which you can buy/sell), the premium (what you pay for the option), and the expiry date (when the right expires). These three components determine an option's value and trading strategy.

1. Strike Price (Exercise Price)

Why Strike Price Matters

The strike price determines whether an option has intrinsic value:

For Call Options:

• In-the-Money (ITM): Market price > Strike price (profitable to exercise)
• At-the-Money (ATM): Market price ≈ Strike price (break-even)
• Out-of-the-Money (OTM): Market price < Strike price (loss if exercised)

For Put Options:

• In-the-Money (ITM): Market price < Strike price (profitable to exercise)
• At-the-Money (ATM): Market price ≈ Strike price (break-even)
• Out-of-the-Money (OTM): Market price > Strike price (loss if exercised)

2. Premium (Option Price)

Premium Components

The premium breaks into two parts:

$\text{Premium} = \text{Intrinsic Value} + \text{Time Value}$

Intrinsic Value: Immediate profit if exercised now (covered above)

Time Value: The "hope premium"—what you pay for the possibility that the option becomes more profitable before expiry

What Determines Premium?

The premium depends on six factors (detailed in future notes):

1. Strike price (K): Closer to current price → higher premium
2. Current price (S): Higher intrinsic value → higher premium
3. Time to expiry (T): More time → higher time value
4. Volatility (σ): More volatile stock → higher premium
5. Interest rates (r): Higher rates → slightly affects premium
6. Dividends: Expected dividends → affects call/put differently

3. Expiry Date (Expiration)

Why Expiry Matters

1. Time decay (theta): As expiry approaches, time value erodes—options lose value each day even if the stock doesn't move
2. Exercise decision: On expiry, you must decide to exercise (if ITM) or let it lapse (if OTM)
3. Settlement: Cash-settled options automatically settle at expiry based on closing price

Time to Expiry Impact

The more time remaining, the higher the time value:

$\text{Time Value} \propto \sqrt{T}$

(Roughly follows square-root relationship—doubling time doesn't double time value)

Why square root? Comes from random walk mathematics: standard deviation of price moves scales with $\sqrt{T}$.

Putting It All Together

How Strike, Premium, and Expiry Interact

| Factor | Effect on Premium | Why? | |-----|----------------| | Strike closer to spot | Higher premium | More chance of being ITM | | Strike far from spot | Lower premium | Less likely to be ITM (OTM options are "lottery tickets") | | More time to expiry | Higher premium | More opportunity for favorable moves | | Less time to expiry | Lower premium | Time decay—less chance for movement | | Stock moves toward strike | Premium increases | Rising intrinsic value + hope | | Stock moves away from strike | Premium decreases | Falling intrinsic value |

Connections

• Call and Put Options Overview – These three parameters apply to both
• Intrinsic vs Time Value – Deeper dive into premium components
• Moneyness (ITM, ATM, OTM) – How strike relates to current price
• Time Decay (Theta) – Why expiry matters so much
• Option Greeks – Mathematical sensitivity to these parameters
• Black-Scholes Model – Formula that prices options using these inputs

Summary

The three pillars of every option contract:

1. Strike Price (K): The fixed price at which you can exercise—determines intrinsic value
2. Premium (P): The upfront cost—your maximum loss, composed of intrinsic + time value
3. Expiry (T): The deadline—time decay accelerates as this approaches

Key insight: Premium is always≥ intrinsic value until expiry. The difference is time value, which reflects the "hope" that the option becomes more profitable. Time decay is the enemy of option buyers and the friend of option sellers.

#flashcards/stock-market

What are the three fundamental parameters of every option contract? :: Strike price (exercise price), Premium (option price), and Expiry date

Concept Map

Hinglish (regional understanding)