The Options Clearing Corporation (OCC), the primary options clearinghouse*, is responsible for standardizing options contracts. Standardization results in each contract maintaining similar characteristics, rules, and presentation. This structure ensures the options markets are liquid by making it relatively easy for investors to trade options. If each contract was customized, investors would be required to study the contract components before executing transactions.
*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 better understand the components of an options contract, we’ll need to break it down and discuss each part.
First, it will state if the customer is long or short the contract. Long represents a purchase of the contract, which provides a right to the investor. Short represents a sale of the contract, which creates an obligation for the investor.
Next, the number ‘1’ represents the number of contracts the customer is buying or selling. Equity options contracts typically cover 100 shares of stock per contract.
‘ABC’ refers to the fictitious underlying stock that the option covers. 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’ refers to the expiration month. If you recall, options expire on the third Friday of the month at 11:59pm ET. This customer’s contract will expire on the third Friday in January precisely at 11:59pm ET (10:59pm CT).
‘40’ represents the strike price of the option. The strike price is an essential part of the contract that signifies the option’s exercise price. If the customer exercises this option, a transaction occurs at $40 per share.
Options are either calls or puts, and we’ll dive deep into the world of calls and puts later in this chapter. For now, calls are contracts that give the right to buy stock, while puts give the right to sell stock.
The ‘$5’ is the premium of the option, which will be discussed in more detail later in this unit. This contract is actually trading for $500, not $5. Remember, options contracts cover 100 shares. Because of this dynamic, premiums represent the cost of the option on a per-share basis. To make it easy, multiply every premium you see by 100 to find the actual price of the contract.
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 provide different rights and obligations, but otherwise function similarly. You’ll need to know how each option operates and how investors utilize them.
Calls are contracts that provide the right to buy an asset at a fixed price. If you were to purchase an equity call, you would gain the right to buy stock at the strike price. This right will only be exercised if the stock’s market price rises above the strike price. For example, a 40 call, which provides the right to buy stock at $40, would be exercised if the stock’s market price were above $40. To fulfill 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 option holder (buyer) pays $500 to gain the right to buy 100 shares of ABC stock at $40. The option writer (seller) receives the $500 premium. If the holder exercises the contract, the writer must sell 100 shares of stock at $40.
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 take those shares and sell them in the market immediately. Selling 100 shares at $60 in the market nets a $2,000 gain. Don’t forget - the premium needs to be factored in to determine the overall gain or loss. Spending $500 on the premium reduces the holder’s overall profit 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 |
In this example, the contract gained intrinsic value when the market price increased to $60. The contract is “in the money,” which is good for the holder, but bad for the writer. The option is assigned (exercised), forcing the writer to deliver 100 shares at $40 per share. Assuming they didn’t already own the stock, they must purchase the shares in the market. Purchasing the 100 shares of stock at $60 and selling at $40 at exercise locks in a $20 per share loss, amounting to a total loss of $2,000. The writer received a $500 premium upfront, bringing their overall loss down to $1,500.
You may have noticed the opposite nature of options. In the previous example, the holder and writer realized gains and losses that were perfectly opposite. While this occurs somewhat frequently, it isn’t always the case with options. For example, if the writer already owned the stock and didn’t need to go to the market to buy the shares, some of their losses would’ve been covered.
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 |
It’s a bit easier when options expire. When the market fell to $35, the contract went “out of the money” and continued to have no intrinsic value. Why would the holder exercise their right to purchase stock at $40 when the market is trading it at $35? Therefore, the premium is the end of the story. The holder paid for an option they didn’t use.
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, as they keep their premium with no additional action taken.
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. Investors who buy equity put contracts gain the right to sell stock at the strike price. Puts are exercised if the stock’s market price falls below the strike price. For example, a 70 put, which provides the right to sell stock at $70, would be exercised if the stock’s market price were below $70. To fulfill 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
The holder pays $300 to gain the right to sell 100 shares of BCD stock at $70. The writer receives $300. If the holder exercises the contract, the writer must buy 100 shares of stock at $70.
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. In this example, the holder can go to the market, purchase 100 shares for $55, then exercise their option and sell the shares at $70. This creates a $1,500 gain, but the premium must be factored in. The $300 premium paid upfront brings the overall gain down to $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. To fulfill the exercise request, the writer must buy 100 shares for $70. Most put writers don’t want the stock they purchase if they get exercised, so it’s safe to assume they go to the market and sell the shares for $55. This creates a loss of $1,500, but the premium must be factored in. The $300 premium received upfront reduces the overall 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 contract went further “out of the money” and continued to have no intrinsic value. Why would the holder exercise their right to sell stock at $70 when the market is trading it at $80? Therefore, the premium is the end of the story. The holder paid for an option they didn’t use.
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 their premium with no additional action taken.
Here’s a video summarizing many of the key points related to put options:
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