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 states 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 transaction occurs at $40 per share.
Options are either calls or puts. We’ll go deeper into calls and puts later in this chapter. For now:
$5 is the option’s premium (discussed in more detail later in this unit). The contract is actually trading for $500, not $5, because equity options cover 100 shares.
To summarize, here’s the contract again:
Long 1 ABC Jan 40 call @ $5
This investor is long one contract that gives them the right to buy 100 shares of ABC stock at $40 per share. The cost of the contract was $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 (the strike price). If you buy an equity call, you gain the right to buy stock at the strike price.
A call is typically exercised only if 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, call writers are 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 and doesn’t change the contract terms.
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 can sell those shares in the market at $60. That’s a $20 per share gain, or $2,000 total. After subtracting the $500 premium paid, the net gain is $1,500.
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 increases to $60, the call becomes in the money and is exercised. The writer is assigned and must deliver 100 shares at $40 per share. If the writer doesn’t already own the stock, they must buy 100 shares in the market at $60 and then sell them at $40 through assignment. That’s a $20 per share loss ($2,000 total), partially offset by the $500 premium received, for a net loss of $1,500.
Options often produce opposite outcomes for the holder and writer, as in the example above. However, the details can change depending on the writer’s situation. For example, if the writer already owned the stock, they wouldn’t need to buy shares in the market to deliver them.
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 market is offering the stock at $35. The option expires unused, so the premium paid ($500) is the holder’s total loss.
How about the writer?
Answer = $500 gain
| Action | Result |
|---|---|
| Sell call | +$500 |
| Total | +$500 |
The holder’s loss is the writer’s gain. When a call expires out of the money, the writer keeps the premium and doesn’t have to take any 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 (the strike price). Investors who buy equity puts gain the right to sell stock at the strike price.
A put is typically exercised if 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, put writers are 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 and doesn’t change the contract terms.
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 at $55, then exercise the put and sell those shares at $70. That’s a $15 per share gain ($1,500 total). After subtracting the $300 premium paid, the net gain is $1,200.
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. Many put writers don’t want to keep the stock, so they may sell it in the market at $55. That creates a $15 per share loss ($1,500 total), partially offset by the $300 premium received, for a net loss of $1,200.
Now let’s see what happens if the market moves in the opposite direction.
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 out of the money and has no intrinsic value. The holder wouldn’t exercise the right to sell at $70 when the market is offering $80. The option expires unused, so the premium paid ($300) is the holder’s total loss.
How about the writer?
Answer = $300 gain
| Action | Result |
|---|---|
| Sell put | +$300 |
| Total | +$300 |
The holder’s loss is the writer’s gain. When a put expires out of the money, the writer keeps the premium and doesn’t have to take any further action.
Here’s a video summarizing many of the key points related to put options:
Swaps are derivative contracts typically traded over the counter (OTC). Institutions use swaps to hedge or speculate on changes in financial variables like interest rates, currencies, or credit risk. Swaps are not traded on an exchange; instead, they are negotiated privately between parties. This allows customization, but it also introduces counterparty risk. Common swap types are interest rate or currency swaps, where principal and interest payments in different currencies are exchanged. Swaps are unsuitable for retail investors; they are used mainly by institutional investors.
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