Options
An option is a contract that gives the buyer the right (but not the obligation) to buy or sell an underlying asset at a specified price within a specified time. The seller (also called the writer) takes on the obligation if the buyer chooses to exercise.
Key Terms
- Premium: The price the buyer pays to purchase the option. This is the buyer's maximum loss
- Strike (exercise) price: The predetermined price at which the underlying asset can be bought (call) or sold (put)
- Expiration date: The last date the option can be exercised. After this date, the contract is worthless
- Underlying asset: The security, index, or commodity the option is based on (stocks are the most common)
Calls vs. Puts
There are two types of options, and each serves a different purpose:
| Feature | Call Option | Put Option |
|---|---|---|
| Right granted | Right to buy the underlying at the strike price | Right to sell the underlying at the strike price |
| Buyer's outlook | Bullish (expects the price to rise) | Bearish (expects the price to fall) |
| Seller's outlook | Neutral to bearish | Neutral to bullish |
| Buyer profits when | Market price rises above strike price + premium | Market price falls below strike price - premium |
Think of it this way: A call option is like a rain check at a store. You lock in today's price and can buy later if the price goes up. A put option is like an insurance policy; you lock in a selling price in case the value drops.
Exam Tip: Gotchas
- The buyer has a right; the seller has an obligation. The buyer chooses whether to exercise. The seller must perform if the buyer exercises. A common exam trap is reversing these roles.
The Four Basic Option Positions
Every option trade has a buyer and a seller. Combined with the two option types, this creates four basic positions, and the exam frequently tests the risk/reward profile of each.
| Position | Market View | Maximum Gain | Maximum Loss |
|---|---|---|---|
| Long call (buy a call) | Bullish | Unlimited (stock can rise indefinitely) | Premium paid |
| Short call (sell/write a call) | Bearish/neutral | Premium received | Unlimited (uncovered) |
| Long put (buy a put) | Bearish | Strike price - premium (stock can fall to zero) | Premium paid |
| Short put (sell/write a put) | Bullish/neutral | Premium received | Strike price - premium |
Key pattern: Option buyers have limited loss (the premium) and potentially large gains. Option sellers have limited gains (the premium) and potentially large losses.
Exam Tip: Gotchas
- Option buyers can never lose more than the premium paid. This is one of the most frequently tested option concepts.
- Short (uncovered) call writers face unlimited loss because there is no ceiling on how high a stock can rise.
How Options Are Used
Options serve three primary purposes:
Hedging
- Protective put: An investor who owns stock buys a put option to protect against a decline in the stock's price (like buying insurance on the position)
- Covered call: An investor who owns stock sells a call option to generate income from the premium. If the stock stays below the strike price, they keep the premium and the stock
Exam Tip: Gotchas
- "Covered" means the writer owns the underlying stock. A covered call is less risky than an uncovered (naked) call because the writer already has the shares to deliver if exercised.
Speculation
- Using options to profit from anticipated price movements with a small capital outlay
- A speculator who expects a stock to rise can buy calls instead of buying the stock itself. The cost is just the premium, not the full share price
- Leverage works both ways: if the stock does not move as expected, the entire premium is lost
Income Generation
- Writing covered calls on securities the investor already owns
- The investor collects the premium as income
- Tradeoff: if the stock rises above the strike price, the investor must sell the shares at the strike price, capping their upside