Option Premium

A call option whose strike price sits above the current market price of the underlying stock trades at a premium of 2. That premium consists of

1. A.intrinsic value of 2 and no time value at all.Wrong. Immediate exercise would cost more than buying the stock outright, so nothing is intrinsic here.
2. B.time value of 2 and no intrinsic value at all.Correct. With the strike above the market, everything the buyer is paying for lies in the future.
3. C.intrinsic value and time value in roughly equal proportions.Wrong. That split requires the option to be in the money, which a strike above the market is not.
4. D.neither, since an out-of-the-money option cannot command a premium.Wrong. The chance of a move before expiration is exactly what buyers are paying for.

Why: An option premium always divides into intrinsic value, which is what the holder would gain by exercising immediately, and time value, which is what the market charges for the possibility of a favourable move before expiration. A call whose strike lies above the market price would produce nothing on immediate exercise, so its intrinsic value is zero and the whole premium is time value. That is why an out-of-the-money option loses value steadily if the underlying does not move. Once the stock rose above the strike, intrinsic value would appear and the premium would split between the two components.

An investor exercised a call option (strike 50, premium paid 3) and later sold the acquired stock at 62. Her capital gain computation uses a basis of:

1. A.$62 - the sale priceWrong. Sale price is proceeds, never basis.
2. B.$50 - the strike aloneWrong-but-tempting. Ignoring the premium double-counts it as a separate loss.
3. C.$47 - strike minus premiumWrong. SUBTRACTION belongs to assigned PUT WRITERS.
4. D.$53 - the strike price plus the premium paidCorrect. The premium becomes part of the stock's cost.

Why: Call exercisers add the option premium to the strike for stock basis: $53, yielding a $9 gain on sale at 62, with the holding period beginning at exercise. Citation: IRS Pub. 550 options taxation. Takeaway: exercised call = strike plus premium basis; the clock starts at exercise.