Options Basics
Introduction to Options
Options are derivative securities whose value is derived from an underlying asset, most commonly stocks. An option is a contract that gives the holder (buyer) the right, but not the obligation, to buy or sell an underlying security at a specified price (the strike price) on or before a specified date (the expiration date). The seller (writer) of the option has an obligation to fulfill the contract if the buyer exercises.
Options are one of the most heavily tested topics on the Series 7 exam. You must understand the mechanics of each position, how to calculate maximum gain, maximum loss, and breakeven points, and how options relate to an investor's overall portfolio strategy. This chapter covers the fundamentals; the next chapter covers multi-leg strategies like spreads and straddles.
Definition
Option Contract: A standardized contract representing the right (for the buyer) or obligation (for the seller/writer) to buy or sell 100 shares of an underlying stock at a specific strike price, on or before the expiration date. Options are issued and guaranteed by the Options Clearing Corporation (OCC).
The Two Types: Calls and Puts
There are only two types of options contracts:
- Call Option: Gives the buyer the RIGHT to BUY 100 shares of the underlying stock at the strike price. The seller (writer) of a call has the OBLIGATION to SELL 100 shares at the strike price if the buyer exercises.
- Put Option: Gives the buyer the RIGHT to SELL 100 shares of the underlying stock at the strike price. The seller (writer) of a put has the OBLIGATION to BUY 100 shares at the strike price if the buyer exercises.
Mnemonic
Remember: "Call Up, Put Down." Call buyers want the stock to go UP (they profit when the price rises above the strike). Put buyers want the stock to go DOWN (they profit when the price falls below the strike).
Options Contract Specifications
Every listed options contract has standardized terms:
- Underlying asset: The specific stock (e.g., XYZ common stock)
- Contract size: 100 shares per contract (standard equity option)
- Strike price (exercise price): The price at which the underlying stock can be bought (call) or sold (put)
- Expiration date: The last date the option can be exercised. Standard equity options expire on the third Friday of the expiration month.
- Premium: The price paid by the buyer to the writer for the option contract. Quoted on a per-share basis, so a premium of $3 means a total cost of $300 per contract (since each contract covers 100 shares).
Example
Reading an option: "1 XYZ July 50 Call @ $3" means:
- 1 = one contract (100 shares)
- XYZ = underlying stock
- July = expiration month
- 50 = strike price ($50 per share)
- Call = right to buy
- @ $3 = premium of $3 per share = $300 total cost
The buyer pays $300 for the right to purchase 100 shares of XYZ at $50 per share anytime before the July expiration.
Buyer vs. Writer: Rights and Obligations
Every options trade has two sides: a buyer (holder) and a seller (writer). Their rights and obligations are mirror images of each other.
The Buyer (Holder)
The buyer pays the premium and receives the right to exercise the contract. Key characteristics:
- Pays the premium upfront
- Has rights, NOT obligations
- Can exercise, sell the option, or let it expire worthless
- Maximum loss is limited to the premium paid
- Call buyers have potentially unlimited gain; put buyers have substantial (but technically limited) gain
The Writer (Seller)
The writer receives the premium and assumes an obligation to perform if the buyer exercises. Key characteristics:
- Receives the premium upfront
- Has obligations, NOT rights
- Must fulfill the contract if assigned (the buyer exercises)
- Maximum gain is limited to the premium received
- Naked (uncovered) call writers face potentially unlimited loss; put writers face substantial loss
Warning
Writing naked (uncovered) calls carries unlimited risk. If an investor writes a naked call and the stock price rises dramatically, there is no cap on potential losses because there is no theoretical limit to how high a stock price can go. This is why naked call writing requires the highest level of options approval and significant margin.
Opening vs. Closing Transactions
Understanding opening and closing transactions is critical for the Series 7:
- Opening purchase (buy to open): An investor buys an option to establish a new long position. This creates a new contract in the market.
- Opening sale (sell to open): An investor sells/writes an option to establish a new short position. This also creates a new contract.
- Closing sale (sell to close): A long option holder sells the option to close out the position before expiration. The holder takes a profit or loss on the difference between purchase and sale prices.
- Closing purchase (buy to close): A short option writer buys back the same option to close out the position and eliminate the obligation.
Open interest represents the total number of outstanding option contracts that have not been closed, exercised, or expired. An opening transaction increases open interest; a closing transaction decreases it.
Moneyness: In-the-Money, At-the-Money, and Out-of-the-Money
"Moneyness" describes the relationship between the option's strike price and the current market price of the underlying stock. Understanding moneyness is essential for determining whether an option has intrinsic value.
Call Options
- In-the-Money (ITM): Market price is ABOVE the strike price. The call has intrinsic value. Example: Stock at $55, Call strike $50 = $5 ITM.
- At-the-Money (ATM): Market price EQUALS the strike price. No intrinsic value. Example: Stock at $50, Call strike $50.
- Out-of-the-Money (OTM): Market price is BELOW the strike price. No intrinsic value. Example: Stock at $45, Call strike $50.
Put Options
- In-the-Money (ITM): Market price is BELOW the strike price. The put has intrinsic value. Example: Stock at $45, Put strike $50 = $5 ITM.
- At-the-Money (ATM): Market price EQUALS the strike price. No intrinsic value. Example: Stock at $50, Put strike $50.
- Out-of-the-Money (OTM): Market price is ABOVE the strike price. No intrinsic value. Example: Stock at $55, Put strike $50.
Mnemonic
Think of it this way: A call is "in the money" when you could "call" (buy) the stock for less than it's worth. A put is "in the money" when you could "put" (sell) the stock for more than it's worth. If exercising would produce an immediate profit (ignoring premium), the option is in-the-money.
Note that the OCC will automatically exercise any option that is in-the-money by $0.01 or more at expiration, unless the holder instructs otherwise. This is called exercise by exception (or auto-exercise).
The Four Basic Options Positions
Every options strategy is built from four basic building blocks. Mastering these four positions and their profit/loss characteristics is absolutely critical for the Series 7 exam. For each position, you must know the investor's market outlook, maximum gain, maximum loss, and breakeven point.
1. Long Call (Buy a Call)
A long call position is created when an investor buys a call option. This is a bullish strategy. The investor expects the stock price to rise above the strike price plus the premium paid.
- Market outlook: Bullish (expects the stock to rise)
- Maximum gain: Unlimited (as the stock price rises, so does the call's value)
- Maximum loss: Limited to the premium paid
- Breakeven: Strike price + Premium paid
Example
An investor buys 1 XYZ July 50 Call @ $3 (total cost = $300).
- Breakeven: $50 + $3 = $53
- Max loss: $300 (premium paid) — occurs if XYZ is at or below $50 at expiration
- Max gain: Unlimited — if XYZ rises to $70, profit = ($70 - $50 - $3) x 100 = $1,700
2. Short Call (Write/Sell a Call)
A short call position is created when an investor writes (sells) a call option. This is a bearish to neutral strategy. The writer hopes the stock stays at or below the strike price so the option expires worthless and they keep the premium.
- Market outlook: Bearish or neutral (expects the stock to stay flat or decline)
- Maximum gain: Limited to the premium received
- Maximum loss: Unlimited (if uncovered/naked)
- Breakeven: Strike price + Premium received
3. Long Put (Buy a Put)
A long put position is created when an investor buys a put option. This is a bearish strategy. The investor expects the stock price to fall below the strike price minus the premium paid.
- Market outlook: Bearish (expects the stock to decline)
- Maximum gain: Strike price - Premium paid (x 100). The stock can only fall to zero.
- Maximum loss: Limited to the premium paid
- Breakeven: Strike price - Premium paid
4. Short Put (Write/Sell a Put)
A short put position is created when an investor writes (sells) a put option. This is a bullish to neutral strategy. The writer hopes the stock stays at or above the strike price so the option expires worthless.
- Market outlook: Bullish or neutral (expects the stock to stay flat or rise)
- Maximum gain: Limited to the premium received
- Maximum loss: Strike price - Premium received (x 100). The stock can fall to zero, obligating the writer to buy at the strike.
- Breakeven: Strike price - Premium received
| Position | Outlook | Max Gain | Max Loss | Breakeven |
|---|---|---|---|---|
| Long Call | Bullish | Unlimited | Premium paid | Strike + Premium |
| Short Call | Bearish / Neutral | Premium received | Unlimited | Strike + Premium |
| Long Put | Bearish | Strike - Premium (x 100) | Premium paid | Strike - Premium |
| Short Put | Bullish / Neutral | Premium received | Strike - Premium (x 100) | Strike - Premium |
Key Takeaway
Buyers have limited risk (premium paid) and potentially large gains. Writers have limited gains (premium received) and potentially large losses. Calls and puts have the same breakeven formula, but the direction is different: calls ADD the premium to the strike; puts SUBTRACT the premium from the strike. Memorize this table thoroughly for the Series 7.
The Options Clearing Corporation (OCC)
The Options Clearing Corporation (OCC) is the central clearinghouse for all listed options traded in the United States. It plays a critical role in the options market:
- Issues and guarantees all listed option contracts. The OCC is the actual issuer of every options contract, not the exchange.
- Ensures performance: The OCC guarantees that the writer will fulfill their obligation, eliminating counterparty risk for the buyer.
- Standardizes contracts: The OCC standardizes all contract terms (strike prices, expiration dates, contract size).
- Facilitates exercise and assignment: When a buyer exercises, the OCC randomly assigns the obligation to a writer who is short that same option.
Definition
Options Clearing Corporation (OCC): The issuer and guarantor of all listed options contracts in the U.S. The OCC interposes itself between the buyer and the writer, acting as the counterparty to both sides. This eliminates credit risk between individual parties and ensures the integrity of the options market.
Exercise and Assignment
Exercise occurs when the option buyer (holder) decides to invoke their right under the contract. For a call, the buyer exercises to purchase shares at the strike price. For a put, the buyer exercises to sell shares at the strike price.
Assignment is the process by which the OCC notifies a writer that a buyer has exercised. The assigned writer must fulfill the obligation. The OCC uses a random selection process to determine which writer is assigned.
The process works as follows:
- The buyer notifies their broker-dealer they wish to exercise
- The broker-dealer notifies the OCC
- The OCC randomly selects a member firm with a short position in that option
- The selected firm assigns the obligation to one of its customers (using FIFO, random, or another fair method)
- The assigned writer must deliver (call) or purchase (put) the underlying shares
American vs. European Style Options
Options come in two exercise styles:
- American style: Can be exercised at any time from the date of purchase until the expiration date. Most equity (stock) options in the U.S. are American style.
- European style: Can only be exercised at expiration, not before. Most index options are European style.
Both styles can be bought or sold (traded) on the open market at any time before expiration. The difference is only about when the option can be exercised. American style provides more flexibility to the buyer but also more risk of assignment for the writer at any time.
Exam Tip
The Series 7 may test the difference between trading and exercising. Both American and European options can be traded (bought and sold) at any time. The key difference is that American options can be exercised at any time, while European options can only be exercised at expiration. Remember: American = Anytime exercise.
Expiration Cycles
Listed equity options are assigned to one of three expiration cycles:
- January cycle (JAJO): January, April, July, October
- February cycle (FMAN): February, May, August, November
- March cycle (MJSD): March, June, September, December
At any given time, options are typically available for the current month, the next month, and the next two months in the cycle. Additionally, many actively traded stocks also have weekly options (Weeklys) and LEAPS (Long-Term Equity Anticipation Securities), which can have expiration dates up to three years in the future.
Standard equity options expire on the third Friday of the expiration month. The last day to trade is also the third Friday. The holder has until 5:30 PM ET on the expiration date to notify their broker of their exercise decision.
Options Breakeven Quick Reference
Being able to quickly calculate breakeven points is one of the most important skills for the Series 7. Here is a consolidated reference:
Call Options
Breakeven = Strike Price + Premium
This applies to BOTH long calls and short calls. Above the breakeven, the call buyer profits and the call writer loses. Below the breakeven, the call buyer loses and the call writer profits.
Put Options
Breakeven = Strike Price - Premium
This applies to BOTH long puts and short puts. Below the breakeven, the put buyer profits and the put writer loses. Above the breakeven, the put buyer loses and the put writer profits.
Mnemonic
"CAL = Call Add, Put Less" — For Calls, you ADD the premium to the strike to get the breakeven. For Puts, you subtract (LESS) the premium from the strike. This one formula covers all four basic positions.
Deep Dive Options Contract Adjustments for Corporate Actions
When the underlying stock undergoes a corporate action such as a stock split, stock dividend, or reverse split, the OCC adjusts the option contract terms to preserve economic equivalence. Understanding these adjustments is important for Series 7 questions.
Forward Stock Splits (Even Splits): For even splits like 2:1 or 3:1, both the number of contracts and the strike price are adjusted. In a 2:1 split, 1 contract at a $60 strike becomes 2 contracts at a $30 strike. Each contract still covers 100 shares.
Odd Splits and Stock Dividends: For uneven splits (3:2) or stock dividends (10%), the number of contracts stays the same, but the number of shares per contract and the strike price are adjusted. In a 3:2 split, 1 contract at a $60 strike becomes 1 contract covering 150 shares at a $40 strike.
Cash Dividends: Regular quarterly cash dividends do NOT cause option adjustments. Only special (extraordinary) cash dividends result in an option adjustment.
Example: An investor holds 5 XYZ October 80 Calls. XYZ declares a 2:1 stock split. After the split, the investor will hold 10 XYZ October 40 Calls. Each contract still covers 100 shares. Total shares controlled: still 1,000 (10 x 100).
Check Your Understanding
Test your knowledge of options basics. Select the best answer for each question.
1. An investor buys 1 ABC July 60 Call @ $4. What is the maximum loss and breakeven point?
2. XYZ stock is trading at $43. An XYZ 45 Put is trading at $5. What is the intrinsic value and time value of the put?
3. Which of the following positions has unlimited risk?
4. The Options Clearing Corporation (OCC) performs all of the following functions EXCEPT:
5. An investor writes 1 DEF August 35 Put @ $2. What is the investor's maximum gain and breakeven point?