Let’s look at what an options contract typically looks like:
Long 1 ABC Jan 40 call @ $5
To understand what this means, break the contract into its parts.
First, the contract tells you whether the customer is long or short:
Next, the number 1 is the number of contracts being bought or sold. Equity options contracts typically cover 100 shares of stock per contract.
ABC is the (fictitious) underlying stock the option is based on. In the real world, ABC could be replaced by Bank of America Corp. (ticker: BAC), Meta Platforms Inc. (ticker: META), Home Depot Inc. (ticker: HD), or any other publicly traded stock.
Jan is the expiration month. Options expire on the third Friday of the month at 11:59pm ET. This contract expires on the third Friday in January at 11:59pm ET (10:59pm CT).
40 is the strike price. The strike price is the option’s exercise price. If the customer exercises this option, the stock transaction happens at $40 per share.
Options are either calls or puts. We’ll go deeper into calls and puts later in this chapter. For now:
The $5 is the option’s premium (covered in more detail later in this unit). The premium is quoted per share, but the contract covers 100 shares.
To summarize, here’s the contract again:
Long 1 ABC Jan 40 call @ $5
This investor bought one call contract that gives the right to buy 100 shares of ABC at $40 per share. The contract cost $500.
Calls and puts are the two types of options contracts available to investors. They provide different rights and obligations, but otherwise work in similar ways. You’ll want to know how each option operates and how investors use them.
Calls are contracts that provide the right to buy an asset at a fixed price. If you buy an equity call, you gain the right to buy stock at the strike price.
A call is typically exercised only when the stock’s market price rises above the strike price. For example, a 40 call (right to buy at $40) would be exercised if the stock’s market price were above $40.
To satisfy the holder’s right, the call writer is obligated to sell stock at the strike price.
Let’s walk through a few examples:
1 ABC Jan 40 call @ $5 while the market price is $39
In this scenario:
The contract expires on the third Friday in January at 11:59pm ET. The market price of $39 is just context for ABC’s current price.
1 ABC Jan 40 call @ $5 while the market price is $39. The market price subsequently rises to $60.
The contract now has $20 of intrinsic value and will be exercised. How much does the holder gain or lose?
Answer = $1,500 gain
| Action | Result |
|---|---|
| Buy call | -$500 |
| Exercise - buy shares | -$4,000 |
| Sell shares | +$6,000 |
| Total | +$1,500 |
Calls go “in the money” (gain intrinsic value) when the market rises. If the holder exercises and buys 100 shares at $40, they’ll typically sell those shares in the market. Selling 100 shares at $60 creates a $2,000 gain, but you must subtract the $500 premium paid. That leaves a $1,500 net gain.
How about the writer?
Answer = $1,500 loss
| Action | Result |
|---|---|
| Sell call | +$500 |
| Buy shares | -$6,000 |
| Assigned - sell shares | +$4,000 |
| Total | -$1,500 |
When the market price rises to $60, the call becomes “in the money,” which benefits the holder and hurts the writer. If assigned, the writer must deliver 100 shares at $40. If the writer doesn’t already own the stock, they must buy 100 shares at $60 and then sell them at $40, locking in a $2,000 loss. The $500 premium received reduces the net loss to $1,500.
You may have noticed the opposite nature of options. In the previous example, the holder and writer had equal and opposite results. That often happens, but not always. For example, if the writer already owned the stock and didn’t need to buy shares in the market, some of the loss would be offset.
Now let’s see what happens if the market moves the other way.
1 ABC Jan 40 call @ $5 while the market price is $39. The market price subsequently falls to $35.
The contract has no intrinsic value and will expire. How much does the holder gain or lose?
Answer = $500 loss
| Action | Result |
|---|---|
| Buy call | -$500 |
| Total | -$500 |
When the market falls to $35, the call is “out of the money” and has no intrinsic value. The holder wouldn’t exercise the right to buy at $40 when the stock is available at $35 in the market. The premium is the entire result.
How about the writer?
Answer = $500 gain
| Action | Result |
|---|---|
| Sell call | +$500 |
| Total | +$500 |
The holder’s loss is the writer’s gain. If the option expires, the writer keeps the premium and takes no further action.
Here’s a video summarizing many of the key points related to call options:
Puts are contracts that provide the right to sell at a fixed price. If you buy an equity put, you gain the right to sell stock at the strike price.
A put is typically exercised when the stock’s market price falls below the strike price. For example, a 70 put (right to sell at $70) would be exercised if the stock’s market price were below $70.
To satisfy the holder’s right, the put writer is obligated to buy stock at the strike price.
Let’s walk through a few examples:
1 BCD Aug 70 put @ $3 while the market price is $71
In this scenario:
The contract expires on the third Friday in August at 11:59pm ET. The market price of $71 is just context for BCD’s current price.
1 BCD 70 put @ $3 while the market price is $71. The market subsequently falls to $55.
What is the gain or loss for the holder?
Answer = $1,200 gain
| Action | Result |
|---|---|
| Buy put | -$300 |
| Buy shares | -$5,500 |
| Exercise - sell shares | +$7,000 |
| Total | +$1,200 |
Puts go “in the money” (gain intrinsic value) when the market falls. Here, the holder can buy 100 shares in the market for $55 and then exercise the put to sell them for $70. That’s a $1,500 gain, minus the $300 premium, for a $1,200 net gain.
How about the writer?
Answer = $1,200 loss
| Action | Result |
|---|---|
| Sell put | +$300 |
| Exercise - buy shares | -$7,000 |
| Sell shares | +$5,500 |
| Total | -$1,200 |
With the contract $15 “in the money,” it is assigned. The writer must buy 100 shares at $70. Most put writers don’t want to keep the stock, so they’ll typically sell the shares in the market for $55. That creates a $1,500 loss, offset by the $300 premium received, for a $1,200 net loss.
Now let’s see what happens if the market moves the other way.
1 BCD Aug 70 put @ $3 while the market price is $71. The market price subsequently rises to $80.
How much does the holder gain or lose?
Answer = $300 loss
| Action | Result |
|---|---|
| Buy put | -$300 |
| Total | -$300 |
When the market rises to $80, the put is further “out of the money” and has no intrinsic value. The holder wouldn’t exercise the right to sell at $70 when the stock can be sold for $80 in the market. The premium is the entire result.
How about the writer?
Answer = $300 gain
| Action | Result |
|---|---|
| Sell put | +$300 |
| Total | +$300 |
The holder’s loss is the writer’s gain. If the option expires, the writer keeps the premium and takes no further action.
Here’s a video summarizing many of the key points related to put options:
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