In 1973, the Chicago Board Options Exchange opened its doors and changed finance forever. Before then, options were obscure contracts traded informally. The CBOE standardized everything and created a clearinghouse to guarantee every trade.
Options are among the most heavily tested topics on the Series 7. Master the fundamentals in this chapter before tackling advanced strategies in Chapter 10.
Section 1: Options Basics
What Is an Option?
An option is a contract between two parties. The holder (buyer) pays a premium to the writer (seller). In exchange, the holder receives a right, while the writer takes on an obligation.
- Speculation: Betting on price direction
- Hedging: Protecting an existing position
- Income generation: Earning premium on existing positions
Call Options
A call option gives the holder the right to BUY the underlying security at the strike price. The writer has the obligation to SELL if exercised.
Buy 1 ABC Jan 50 Call @ $5
The holder can buy 100 shares of ABC at $50/share until January expiration, regardless of market price. Premium paid: $500.
Put Options
A put option gives the holder the right to SELL the underlying security at the strike price. The writer has the obligation to BUY if exercised.
Buy 1 ABC Jan 50 Put @ $5
The holder can sell 100 shares of ABC at $50/share until January expiration, regardless of market price. Premium paid: $500.
Contract Outcomes
The holder has three choices:
- Exercise - Use the right (buy/sell at strike price)
- Let expire - Lose the premium paid
- Trade - Sell the contract to close the position
Test Tip: Stock options are American style (can exercise any time). Most index options are European style (can only exercise at expiration).
The OCC
The Options Clearing Corporation (OCC) creates standardized contracts, guarantees settlement, and acts as the clearinghouse for all listed options.
| Position | Role | Has |
|---|---|---|
| Call Buyer | Long | RIGHT to BUY |
| Call Writer | Short | OBLIGATION to SELL |
| Put Buyer | Long | RIGHT to SELL |
| Put Writer | Short | OBLIGATION to BUY |
Section 2: Options Pricing
Premium = Intrinsic Value + Time Value
Intrinsic Value
Intrinsic value is the amount an option is in the money (ITM). It's the immediate exercise value.
| Option Type | In the Money When... |
|---|---|
| Call | Market price > Strike price |
| Put | Market price < Strike price |
Time Value
Time value is the premium amount beyond intrinsic value. It represents the possibility that the option will become more valuable before expiration. Time value decreases as expiration approaches (time decay).
Test Tip: Intrinsic value can never be negative—it's either positive (in the money) or zero (at/out of the money). Buyers want intrinsic value; writers want time value only (option expires worthless).
| Term | Definition |
|---|---|
| In the Money (ITM) | Option has intrinsic value |
| At the Money (ATM) | Strike = Market price |
| Out of the Money (OTM) | No intrinsic value |
Section 3: Speculative Strategies
Speculative strategies involve betting on price direction. Buyers profit when the market moves in their favor; writers profit when it stays stable or moves against buyers.
Long Call (Bullish)
| Market Bias | Bullish |
| Max Gain | Unlimited |
| Max Loss | Premium paid |
| Breakeven | Strike + Premium |
Short Call (Bearish)
| Market Bias | Bearish |
| Max Gain | Premium received |
| Max Loss | Unlimited |
| Breakeven | Strike + Premium |
Long Put (Bearish)
| Market Bias | Bearish |
| Max Gain | Strike - Premium (stock goes to zero) |
| Max Loss | Premium paid |
| Breakeven | Strike - Premium |
Short Put (Bullish)
| Market Bias | Bullish |
| Max Gain | Premium received |
| Max Loss | Strike - Premium (stock goes to zero) |
| Breakeven | Strike - Premium |
Test Tip: The call buyer has unlimited upside; the call writer has unlimited downside. For puts, both max gain and max loss are limited (stock can only go to zero).
| Strategy | Bias | Max Gain | Max Loss |
|---|---|---|---|
| Long Call | Bullish | Unlimited | Premium |
| Short Call | Bearish | Premium | Unlimited |
| Long Put | Bearish | Strike - Premium | Premium |
| Short Put | Bullish | Premium | Strike - Premium |
Section 4: Protective Strategies
Protective strategies use options to hedge existing stock positions against adverse price moves.
Protective Put (Long Stock + Long Put)
A customer who owns stock can buy a put to protect against downside risk. If the stock falls, they can sell at the strike price. If it rises, they keep the upside (minus premium paid).
- Protection: Full downside protection
- Max Loss: Premium paid
- Max Gain: Unlimited (stock can rise infinitely)
- Cost: Reduces return by premium amount
Protective Call (Short Stock + Long Call)
A customer who is short stock can buy a call to protect against upside risk. If the stock rises, they can buy at the strike price to cover. If it falls, they profit on the short (minus premium).
- Protection: Full upside protection
- Max Loss: Premium paid
- Max Gain: Stock price - Premium (stock goes to zero)
| Stock Position | Hedge With | Protection Type |
|---|---|---|
| Long Stock | Buy Put | Downside protection |
| Short Stock | Buy Call | Upside protection |
Section 5: Options Income Strategies
Income strategies involve writing (selling) options against existing stock positions to generate premium income. This provides partial protection but limits potential gains.
Covered Call (Long Stock + Short Call)
The most common income strategy. The customer owns stock and sells a call against it. Premium received provides income and partial downside protection.
- Market Bias: Neutral to mildly bullish
- Income: Premium received
- Trade-off: Upside is capped at strike price
- Protection: Partial (limited to premium received)
Covered Put (Short Stock + Short Put)
The customer is short stock and sells a put against it. Premium received provides income and partial upside protection.
- Market Bias: Neutral to mildly bearish
- Income: Premium received
- Trade-off: Downside profit is capped
- Protection: Partial (limited to premium received)
| Stock Position | Write Option | Market Bias |
|---|---|---|
| Long Stock | Sell Call | Neutral to mildly bullish |
| Short Stock | Sell Put | Neutral to mildly bearish |
Chapter 9 Key Terms Glossary
| Term | Definition |
|---|---|
| Call option | Right to BUY at strike price |
| Put option | Right to SELL at strike price |
| Holder/Buyer | Has rights; pays premium |
| Writer/Seller | Has obligation; receives premium |
| Premium | Price paid for option contract |
| Strike price | Exercise price of option |
| Intrinsic value | Amount option is in the money |
| Time value | Premium beyond intrinsic value |
| In the money (ITM) | Has intrinsic value |
| Out of the money (OTM) | No intrinsic value |
| American style | Can exercise any time |
| European style | Can only exercise at expiration |
| OCC | Options Clearing Corporation |
| Covered call | Long stock + short call |
| Protective put | Long stock + long put |
Chapter 9 introduces the fundamentals of options. Master these concepts before moving to Chapter 10: Index Options and Advanced Options Strategies.