Options: Puts, Calls, and How They Work

Options items on the SIE stay at the level of the contract. They ask who holds the right, who carries the obligation, and what happens on exercise.

Calls and puts: two contracts, four positions

An option is a contract on an underlying security. One standard equity option contract covers 100 shares, unless a corporate action adjusts it.

A call gives its owner the right to buy the underlying stock at a set price until expiration. A put gives its owner the right to sell the underlying stock at a set price until expiration.

The buyer is the holder and is long the option. The holder has a right and no obligation. The seller is the writer and is short the option. The writer has an obligation and no right, and must perform if the holder exercises.

That gives you four positions:

• Long call: the right to buy at the strike.
• Short call: the obligation to sell at the strike if assigned.
• Long put: the right to sell at the strike.
• Short put: the obligation to buy at the strike if assigned.

The holder chooses. The writer waits. The exam swaps these two constantly.

Strike, premium, and expiration

Three terms define every contract. The strike price, also called the exercise price, is the price at which the holder buys (call) or sells (put) the stock. The premium is the price of the option itself: intrinsic value plus time value. The expiration date is the day the option and the right to exercise it end.

The premium is quoted per share, so multiply by 100 for the cost of one contract. Buy one OICX July 60 call at $4 and you pay $400. That $400 buys the right to purchase 100 shares at $60 each until July expiration.

The buyer can lose no more than the premium. The writer keeps the premium if the option expires unexercised. For a standard monthly equity option, the last trading day is generally the third Friday of the expiration month.

In, at, and out of the money

Moneyness compares the stock price with the strike:

• A call is in the money when the stock trades above the strike.
• A put is in the money when the stock trades below the strike.
• Either contract is at the money when the stock price equals the strike.
• A call is out of the money below the strike, and a put is out of the money above it.

Intrinsic value is the amount by which an option is in the money. An out-of-the-money option has no intrinsic value, so its premium is all time value. It expires worthless.

Equity options and index options

An equity option has one stock or ETF as its underlying security. Exercise moves shares: the call holder buys 100 shares and the put holder sells 100 shares. That stock trade settles on the normal T+1 timetable.

An index option has an index as its underlying interest, such as the S&P 100. Nobody can deliver an index, so index options are generally cash settled. The writer pays the holder the exercise settlement amount: the difference between the strike and the index settlement value.

Exercise style splits the same way. American style lets the holder exercise on any day the market is open, up to expiration. All standardized equity options are American style. European style lets the holder exercise only on the last trading day before expiration. Most index options are European style.

Covered and uncovered writing

A covered option is a short option offset by a matching position, so the writer can meet delivery. Sell one call against 100 shares you own and you have a covered call.

An uncovered call, or naked call, is a short call on stock the writer does not own. Before you write one, price the exposure. Assignment forces that writer to buy the stock at whatever the market asks, and a stock price has no ceiling.

A short put backed by enough cash to buy the shares is a cash-secured put. An uncovered put writer has neither that cash nor a short stock position.

Exercise, assignment, and the OCC

Exercise is the holder using the right. Assignment is the writer being called on to perform. The writer has no say.

The customer tells the broker-dealer to exercise. The firm sends the notice to the Options Clearing Corporation (OCC). OCC is the clearing organization that stands between buyer and seller on every listed option. OCC assigns the notice at random to a clearing member short that series. The firm then allocates it to a customer, at random or first in, first out.

Random is the word the exam wants. Any writer holding that series is at risk of assignment on any day.

At expiration, OCC's exercise by exception procedure exercises contracts in the money by $0.01 or more, unless the clearing member instructs otherwise.

Hedging, speculation, and the ODD

Customers use options for two reasons. Hedging protects a position: an investor holding 100 shares buys a put to set a floor sale price, and a covered call on those shares collects income. Speculation bets on direction with a smaller outlay than the stock would need.

Before a customer trades any option, the broker-dealer must deliver the options disclosure document (ODD), titled Characteristics and Risks of Standardized Options. OCC prepares it; the firm delivers it. SEC Rule 9b-1 under the Securities Exchange Act of 1934 sets the ODD deadline. The firm must deliver it at or before it approves the account for options trading.

How this gets tested

Most items name a position and ask what that person may or must do. Read for the side and the type of contract.

A question about who must deliver stock is asking about a short call. A question naming an index option is testing cash settlement or European-style exercise. An option in the money by $0.01 at expiration is testing exercise by exception.