Options Basics

Options Fundamentals

An option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price (the strike price) on or before a specific date (the expiration date). Options are powerful financial instruments used for speculation, income generation, and hedging. The SIE exam tests fundamental options concepts, not complex strategies.

Key Options Terminology

• Call Option: Gives the buyer the right to buy the underlying security at the strike price.
• Put Option: Gives the buyer the right to sell the underlying security at the strike price.
• Premium: The price paid by the buyer to the seller (writer) for the option contract. This is the cost of acquiring the right.
• Strike (Exercise) Price: The predetermined price at which the underlying security can be bought (call) or sold (put).
• Expiration Date: The last date on which the option can be exercised. Standard equity options expire on the third Friday of the expiration month.
• Buyer (Holder): The party that purchases the option and pays the premium. The buyer has rights.
• Seller (Writer): The party that sells the option and receives the premium. The writer has obligations.
• Contract Size: One standard equity option contract covers 100 shares of the underlying stock.

American vs. European Style

American-style options can be exercised at any time before or on the expiration date. Most equity options in the U.S. are American-style.

European-style options can only be exercised on the expiration date itself. Most index options are European-style.

The naming has nothing to do with geography; both types trade globally.

The Options Clearing Corporation (OCC)

The Options Clearing Corporation (OCC) is the central clearinghouse for all listed options in the United States. It serves as the guarantor for every options contract, ensuring that the terms are fulfilled. When a buyer exercises an option, the OCC randomly assigns the exercise notice to a writer of that option. The OCC issues the options disclosure document (ODD), which must be provided to customers before they can trade options.

Call Options

A call option gives the buyer the right to purchase 100 shares of the underlying stock at the strike price on or before the expiration date. The call buyer pays a premium for this right and is bullish — expecting the stock price to rise above the strike price plus the premium paid.

Long Call (Buyer)

• Outlook: Bullish
• Maximum Gain: Unlimited (the stock can rise without limit)
• Maximum Loss: Limited to the premium paid
• Breakeven: Strike Price + Premium

The long call buyer profits when the stock price rises above the breakeven point. If the stock stays at or below the strike price, the option expires worthless and the buyer loses only the premium paid.

Short Call (Writer/Seller)

• Outlook: Neutral to slightly bearish
• Maximum Gain: Limited to the premium received
• Maximum Loss: Unlimited (obligated to sell shares at the strike price, regardless of how high the market price goes)
• Breakeven: Strike Price + Premium

The call writer collects the premium upfront and hopes the option expires worthless. If the stock rises sharply, the writer faces potentially unlimited losses because they must sell the stock at the strike price, no matter how high the market goes.

Put Options

A put option gives the buyer the right to sell 100 shares of the underlying stock at the strike price on or before the expiration date. The put buyer is bearish — expecting the stock price to decline below the strike price minus the premium paid.

Long Put (Buyer)

• Outlook: Bearish
• Maximum Gain: Strike Price - Premium (the stock can only go to $0)
• Maximum Loss: Limited to the premium paid
• Breakeven: Strike Price - Premium

Short Put (Writer/Seller)

• Outlook: Neutral to slightly bullish
• Maximum Gain: Limited to the premium received
• Maximum Loss: Strike Price - Premium (if the stock goes to $0, the writer must still buy at the strike)
• Breakeven: Strike Price - Premium

Options Strategies

While the SIE exam does not require deep knowledge of complex multi-leg options strategies, you should understand the basic hedging strategies that combine options with stock positions. These strategies are commonly used by investors to manage risk or generate income.

Covered Calls

A covered call involves owning the underlying stock and selling (writing) a call option on that stock. This is one of the most conservative options strategies.

• Position: Long 100 shares + Short 1 call option
• Outlook: Neutral to slightly bullish. The investor expects the stock to stay flat or rise modestly.
• Purpose: Generate income from the premium received. The premium provides a small buffer against minor price declines.
• Risk: If the stock rises above the strike price, the shares will be called away (the investor must sell at the strike price, missing out on further upside). If the stock drops significantly, the investor still bears the loss on the stock, though the premium received offsets some of the loss.
• Max Gain: Premium + (Strike Price - Purchase Price of stock). Capped at the strike price.
• Max Loss: Purchase Price of stock - Premium received (if stock goes to $0).

Protective Puts

A protective put (also called a "married put") involves owning the underlying stock and buying a put option on that stock. This is essentially buying insurance on your stock position.

• Position: Long 100 shares + Long 1 put option
• Outlook: Bullish on the stock but concerned about short-term downside risk.
• Purpose: Protect against significant downside loss. The put acts as a floor price — no matter how far the stock falls, you can sell at the strike price.
• Cost: The premium paid for the put reduces overall returns (like paying an insurance premium).
• Max Gain: Unlimited (the stock can rise indefinitely, minus the put premium).
• Max Loss: (Purchase Price of stock - Strike Price of put) + Premium paid.

Straddles Overview

A straddle involves buying (or selling) both a call and a put on the same stock with the same strike price and expiration date.

A long straddle (buy a call + buy a put) is used when an investor expects a large move in either direction but is unsure which way. The investor profits if the stock moves significantly up or down beyond the total premiums paid. Maximum loss is the total premiums paid (if the stock stays at the strike price).

A short straddle (sell a call + sell a put) generates income when the investor expects the stock to remain relatively stable. Maximum gain is the total premiums received. Risk is substantial in both directions.

Options Settlement and Exercise

Understanding how options are exercised, assigned, and settled is important for the SIE exam. This section covers the mechanics of what happens when an option holder decides to exercise their rights.

In-the-Money, At-the-Money, Out-of-the-Money

An option's "moneyness" describes the relationship between the underlying stock's price and the strike price:

• In-the-Money (ITM): The option has intrinsic value. A call is ITM when the stock price is above the strike. A put is ITM when the stock price is below the strike.
• At-the-Money (ATM): The stock price equals the strike price. The option has no intrinsic value but may have significant time value.
• Out-of-the-Money (OTM): The option has no intrinsic value. A call is OTM when the stock price is below the strike. A put is OTM when the stock price is above the strike.

The Exercise and Assignment Process

When an option buyer decides to exercise their option, the process works as follows:

1. The buyer notifies their broker of the intent to exercise.
2. The broker submits an exercise notice to the OCC.
3. The OCC randomly selects a member firm with customers who have written that particular option.
4. The assigned firm selects one of its customers who has written the option (using random selection, first-in-first-out, or another approved method).
5. The assigned writer must fulfill their obligation (sell shares for a call, buy shares for a put).

Equity options settle on a T+1 basis (one business day after exercise). The underlying shares settle on the standard stock settlement cycle.

Automatic Exercise

The OCC automatically exercises options that are in-the-money by $0.01 or more at expiration, unless the holder provides instructions not to exercise. This is called the "exercise by exception" rule. Holders who do not want their ITM options exercised must notify their broker before the cutoff time on expiration day.

Options Expiration Cycle

Standard equity options expire on the third Friday of the expiration month (technically Saturday, but trading stops on Friday). Weekly options (weeklys) expire every Friday and provide shorter-term trading opportunities. LEAPS (Long-term Equity Anticipation Securities) are options with expiration dates up to three years out.