Options Fundamentals

The contract

A standard listed equity option covers 100 shares of the underlying security. Premiums are quoted per share, so a premium of 3.50 means $350 for the contract. Every profit and loss figure in this module is stated per share unless it says otherwise; multiply by 100 at the end, never in the middle, because doing it in the middle is how arithmetic errors get in.

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 the underlying at the strike price. A put gives the holder the right to sell the underlying at the strike price.

The holder — the buyer, the long — has the right and pays the premium. The writer — the seller, the short — has the obligation and receives the premium. Rights are exercised at the holder's option; obligations are performed when assigned.

So the four basic positions read as follows. A long call is the right to buy: bullish. A short call is the obligation to sell if assigned: bearish or neutral. A long put is the right to sell: bearish. A short put is the obligation to buy if assigned: bullish or neutral. Memorize this as a two-by-two rather than four separate facts; questions are constructed by moving around it.

Opening and closing transactions are named from the position's direction. Buying an option you do not hold is an opening purchase; selling one you hold is a closing sale. Writing an option is an opening sale; buying it back is a closing purchase.

The Options Clearing Corporation

Listed options are issued and guaranteed by the Options Clearing Corporation, which sits between every buyer and every seller as the counterparty to both.

That structure has three consequences the exam tests. The contracts are standardized, because the OCC issues them — strike intervals, expiration cycles and contract size are set rather than negotiated. Performance is guaranteed, so a holder exercising does not depend on a particular writer's solvency; the credit risk that would otherwise dominate the market is removed. And positions can be closed by an offsetting trade rather than by finding the original counterparty, which is what makes an options market liquid.

Assignment follows from the same structure. When a holder exercises, the notice goes to the OCC, which assigns it at random to a clearing member firm with a short position in that series. The firm then allocates the assignment to one of its own customers, either at random or on a first-in, first-out basis, under a method disclosed to customers. A writer therefore cannot predict assignment and cannot avoid it; the only way out of the obligation is to close the position before assignment occurs.

The OCC also publishes the Characteristics and Risks of Standardized Options — the options disclosure document, universally the ODD — which must be delivered to a customer at or before the time their account is approved for options trading.

Exercise style, expiration and settlement

American-style options may be exercised on any business day up to and including the expiration date. Listed equity options are American-style.

European-style options may be exercised only at expiration. Most broad-based index options are European-style, and that difference matters for the writer: a European-style index writer cannot be assigned early, while an equity option writer can be assigned at any time.

Equity options expire on the third Friday of the expiration month, and trading in them ordinarily ceases at the close of business on that day. If the third Friday is an exchange holiday, the last trading day moves to the preceding Thursday.

Exercising an equity option produces a stock trade, and that trade settles on the first business day after exercise — the same T+1 cycle as any other stock transaction. Option premium transactions themselves also settle the next business day.

Long-term Equity AnticiPation Securities — LEAPS — are simply options with a long term, listed with up to 39 months from initial listing and expiring in January. They are American-style like other equity options and follow the same third-Friday convention.

Open interest is the number of contracts in a series currently outstanding — opened and not yet closed, exercised or expired. It is a measure of how much of the market is committed to that series, and it rises when a new buyer and a new writer transact and falls when both sides close.

Intrinsic value, time value and moneyness

Premium divides into intrinsic value and time value, and the whole premium of an out-of-the-money option is time value.

A call has intrinsic value when the market price exceeds the strike: intrinsic equals market minus strike. A put has intrinsic value when the strike exceeds the market: intrinsic equals strike minus market. Intrinsic value is never negative — when the subtraction would be negative, intrinsic value is zero and the option is out of the money.

Calls are in the money when the market is above the strike; puts are in the money when the market is below it. Both are at the money when market equals strike. Getting this right is worth more than any formula in the module, and the way to keep it 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.

Time value is premium minus intrinsic value. It decays as expiration approaches, and the decay accelerates in the final weeks — an option is a wasting asset, which is the central risk of every long position in this module. At expiration, time value is zero and the option is worth exactly its intrinsic value.

Worked example. XYZ trades at 62. The XYZ 60 call is quoted at 3.50. Intrinsic value is 62 minus 60, which is 2. Time value is 3.50 minus 2, which is 1.50. The XYZ 60 put with the stock at 62 has no intrinsic value at all; its entire premium is time value.

Contract adjustments

Corporate actions change what a share is, and the OCC adjusts outstanding contracts so their economics survive.

An even split — two-for-one, four-for-one — is handled by multiplying the number of contracts and dividing the strike. One XYZ 60 call after a two-for-one split becomes two XYZ 30 calls, each still on 100 shares. The aggregate exercise value is unchanged: one contract at $6,000 becomes two at $3,000.

An uneven split or a stock dividend is handled by adjusting the strike and the number of shares per contract, leaving the contract count alone. A five-for-four split turns one XYZ 60 call into one call at a strike of 48 covering 125 shares — 60 times four-fifths, and 100 times five-fourths. Again the aggregate value is unchanged at $6,000.

What is not adjusted: ordinary cash dividends. The strike price of a listed option is not reduced when the underlying goes ex-dividend, which is a real economic consequence for a call holder and a reason early exercise of a call sometimes makes sense just before an ex-dividend date. Special or extraordinary cash distributions may be adjusted for, under the exchange's adjustment rules.

A reverse split adjusts in the same style, and mergers, spinoffs and other reorganizations are handled case by case by the OCC, which publishes an adjustment memo for each one.