Options Basics

The contract and the four positions

A standard listed equity option covers 100 shares. Premiums are quoted per share, so a premium of 3.50 means $350 for the contract.

Four terms identify a contract: the underlying security, the expiration month, the strike or exercise price, and the type — call or put.

A call gives the holder the right to buy at the strike. A put gives the holder the right to sell at the strike. The holder pays the premium and has the right; the writer receives the premium and has the obligation.

The four positions, as a two-by-two rather than four separate facts:

Long call — the right to buy. Bullish. Maximum loss is the premium; maximum gain is unlimited.

Long put — the right to sell. Bearish. Maximum loss is the premium; maximum gain is the strike less the premium, because the stock stops at zero.

Short call — the obligation to sell if assigned. Bearish or neutral. Maximum gain is the premium; if uncovered, the maximum loss is unlimited, and this is the only position on the exam with truly unbounded risk.

Short put — the obligation to buy if assigned. Bullish or neutral. Maximum gain is the premium; maximum loss is the strike less the premium.

Breakeven follows one rule: strike plus premium for a call, strike minus premium for a put, and it is the same number for the buyer and the writer of the same contract.

A covered call is a short call written against stock the writer owns, which removes the unlimited risk and caps the upside — the conservative option strategy, used for income and a small cushion. A protective put is a long put against stock owned, which sets a floor for the cost of the premium and leaves the upside unlimited.

Moneyness, intrinsic value and time value

A call is in the money when the market price exceeds the strike; a put is in the money when the strike exceeds the market. Both are at the money when they are equal, and out of the money otherwise.

The way to keep this straight is to reason from the right the option confers. A call holder may buy at the strike, so a higher market price is better for them.

Intrinsic value is the in-the-money amount: market minus strike for a call, strike minus market for a put. It is never negative; when the subtraction would be negative, intrinsic value is zero.

Time value is the premium minus the intrinsic value, and the entire premium of an out-of-the-money option is time value. It decays as expiration approaches and is zero at expiration, which is why an option is described as a wasting asset.

Worked example. A stock trades at 62 and the 60 call is quoted at 3.50. Intrinsic value is 2 and time value is 1.50. The 60 put on the same stock has no intrinsic value at all; its whole premium is time value.

The OCC, exercise and assignment

Listed options are issued and guaranteed by the Options Clearing Corporation, which stands between every buyer and every seller.

Three consequences. Contract terms are standardized rather than negotiated. Performance is guaranteed, so a holder exercising does not depend on a particular writer's solvency. And a position can be closed by an offsetting trade rather than by finding the original counterparty, which is what makes the market liquid.

American-style options may be exercised any business day up to and including expiration; listed equity options are American-style. European-style options may be exercised only at expiration, and most broad-based index options are European-style — so their writers cannot be assigned early.

Assignment is random. When a holder exercises, the notice goes to the OCC, which assigns it at random to a clearing member with a short position; the firm then allocates to a customer at random or first in, first out. A writer cannot avoid assignment except by closing the position first.

Equity options expire on the third Friday of the expiration month. Index options settle in cash — there is nothing to deliver, so exercise produces a payment equal to the in-the-money amount times a multiplier.

Options are used for two purposes: speculation, taking a leveraged directional position with a known maximum loss when long; and hedging, protecting an existing position — a long put for a long stock position, a long call for a short one.

Account requirements and disclosure

An options account requires more than an ordinary one.

The options disclosure document — the OCC's Characteristics and Risks of Standardized Options, universally the ODD — must be furnished to the customer at or prior to the time the account is approved for options transactions. Delivery comes before approval, not after.

A Registered Options Principal approves the account in writing, and the approval specifies which types of transactions are permitted — buying, covered writing, uncovered writing, spreading, discretionary.

Within fifteen days after approval, the firm sends the background and financial information on which it approved the account to the customer for verification and obtains a signed options agreement in which the customer undertakes to abide by exchange and OCC rules and not to exceed position or exercise limits.

Uncovered writing carries additional requirements, including written procedures, specific approval, minimum equity standards, and delivery of a special written description of the risks before the first uncovered transaction. That is a direct consequence of the unlimited loss.

Options communications must be preceded or accompanied by the ODD and approved by a Registered Options Principal, and may not project performance.