The Options Clearing Corporation (OCC), the primary options clearinghouse*, is responsible for standardizing options contracts. Standardization means each contract follows the same basic format, rules, and terms. This consistency helps keep the options markets liquid because investors can trade contracts without having to re-check custom terms each time. If every contract were customized, investors would need to review the contract details before placing each trade.
*A clearinghouse is responsible for ensuring options transactions are correctly executed.
Let’s take a look at what an options contract typically looks like:
Long 1 ABC Jan 40 call @ $5
To understand an options contract, it helps to break it 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, which is the option’s exercise price. If the customer exercises this option, the stock transaction occurs at $40 per share.
Options are either calls or puts, and we’ll dive deeper into calls and puts later in this chapter. For now:
The $5 is the premium of the option, which will be discussed in more detail later in this unit. The contract is actually trading for $500, not $5, because equity options typically cover 100 shares.
To summarize, let’s put everything together. Here’s the contract and breakdown:
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. Both create a relationship between a holder (buyer) and a writer (seller). They differ in the right they give the holder and the obligation they create for the writer, but the mechanics are similar.
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 the stock at the strike price.
A call is typically exercised only when the stock’s market price is above the strike price. For example, a 40 call gives the right to buy at $40, so it 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 only provides context for ABC’s current price. This information is typically useless.
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 purchases 100 shares of ABC stock at $40, they’ll likely sell those shares in the market immediately. Selling 100 shares at $60 creates a $2,000 gain ($20 x 100). The premium must be included when calculating the overall result: paying $500 reduces the net gain to $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 increased to $60, the contract became “in the money.” That benefits the holder but hurts the writer. If the option is exercised, the writer is assigned and must deliver 100 shares at $40 per share. Assuming the writer doesn’t already own the stock, they must buy 100 shares in the market at $60 and then sell them at $40, locking in a $2,000 loss ($20 x 100). The $500 premium received upfront 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, the writer’s outcome would be different.
Let’s see what happens if the market goes in the opposite direction.
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 fell to $35, the call stayed “out of the money” and had no intrinsic value. Exercising would mean buying at $40 when the market offers $35, so the holder won’t exercise. 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. An expiring option is the writer’s best-case scenario because the writer keeps the premium and has no further obligation.
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). If you buy an equity put, you gain the right to sell the stock at the strike price.
A put is typically exercised only when the stock’s market price is below the strike price. For example, a 70 put gives the right to sell at $70, so it 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 only provides context for BCD’s current price. Again, this information is typically useless.
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 those shares at $70. That creates a $1,500 gain ($15 x 100). 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 it’s reasonable to assume they sell the shares in the market for $55. That creates a $1,500 loss ($15 x 100). The $300 premium received reduces the net loss to $1,200.
Let’s see what happens if the market goes 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 rose to $80, the put moved further “out of the money” and still had no intrinsic value. Exercising would mean selling at $70 when the market offers $80, so the holder won’t exercise. 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. An expiring option is the writer’s best-case scenario, as they keep the premium with no additional action taken.
Here’s a video summarizing many of the key points related to put options:
Options contracts are divided into three distinct categories:
Options types refer to calls or puts. All call options are one option type, while all put options are the other option type.
Options classes refer to all calls or puts on the same underlying security. For example, all Target Corporation stock (ticker: TGT) call options are an options class, while all TGT put options are another options class.
Options series refers to all options of a specific class with the same strike price and expiration. For example, all TGT Jan 120 call options are part of the same series, while all TGT Jan 120 put options are part of another series.
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