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 key terms. This consistency helps keep the options markets liquid because investors can trade contracts without having to re-check custom terms every time. If each 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 what this means, we can break the contract into its parts.
First, it states whether the customer is long or short the contract:
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 occurs at $40 per share.
Options are either calls or puts, and we’ll dive deeper into both later in this chapter. For now:
The $5 is the option’s premium, which is discussed in more detail later in this unit. Even though the premium is quoted as $5, the contract is actually trading for $500, not $5.
Here’s why: equity options cover 100 shares, and the premium is quoted per share. To find the total contract price, multiply the quoted premium by 100.
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 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 (the right to buy 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 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. Then you factor in the $500 premium paid, which reduces the 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 |
When the market price increased to $60, the contract became “in the money,” which benefits the holder but hurts the writer. The option is assigned (exercised), forcing the writer to 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 through assignment. That locks in a $20 per share loss ($2,000 total). The writer keeps the $500 premium received upfront, so the overall loss is $1,500.
You may have noticed the opposite nature of options. In the previous example, the holder and writer had gains and losses that were perfectly opposite. This happens often, but not always. For example, if the writer already owned the stock and didn’t need to buy shares in the market, 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 |
When the market fell to $35, the contract stayed “out of the money” and had no intrinsic value. The holder wouldn’t exercise the right to buy at $40 when the market is offering the stock at $35. So the premium is the entire result: 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, because 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. Investors who buy equity put contracts 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 (the right to sell 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
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 option to sell those shares at $70. That creates a $1,500 gain, and then the $300 premium paid reduces the overall gain 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 to keep the stock if they get exercised, so it’s safe to assume they sell the shares in the market for $55. That creates a $1,500 loss, and then 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 moved further “out of the money” and still had no intrinsic value. The holder wouldn’t exercise the right to sell at $70 when the market is paying $80. So, once again, 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 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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