Quick Answer
An option gives its buyer the right, but not the obligation, to buy or sell an underlying asset at a set strike price before expiration. Calls grant the right to buy and fit a bullish view; puts grant the right to sell and fit a bearish view. The buyer's maximum loss is the premium paid; the writer takes on the obligation to perform if the buyer exercises.
Options come in four basic positions, and the exam tests both their risk/reward profiles and how investors use them for hedging, speculation, and income.
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)
What Is the Difference Between Calls and 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 (at expiration) | 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.
What Are 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 (assumes the stock falls to zero) | Premium paid |
| Short put (sell/write a put) | Bullish/neutral | Premium received | Strike price - premium (assumes the stock falls to zero) |
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.
- A short put writer's maximum loss (strike price minus premium) also assumes the stock falls to zero, the same floor that caps a long put's maximum gain. A partial decline produces a smaller loss than the maximum; the writer must buy worthless shares at the strike price only in the worst case.
How Are Options 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
What Should You Check on Exam Day?
- A call gives the right to buy; a put gives the right to sell. The buyer chooses whether to exercise; the writer must perform if exercised
- The premium is the buyer's maximum loss and the writer's maximum gain
- Long call: unlimited gain, premium loss. Short call (uncovered): unlimited loss, premium gain
- Long put: gain capped at strike minus premium (stock can fall to zero). Short put: same cap on loss, premium gain
- A covered call means the writer already owns the underlying stock, which limits the writer's risk compared to an uncovered (naked) call
- Options are used for hedging (protective puts, covered calls), speculation, and income generation (covered calls)