Options

Options are among the most versatile and widely traded financial instruments in the United States securities markets, serving as tools for speculation, income generation, hedging, and portfolio risk management, and they are one of the most extensively tested topics on the SIE and Series 7 examinations.

The Four Contract Terms That Define Every Option

Every standardised equity option contract is defined by exactly four terms that, taken together, uniquely identify the specific contract. These terms are standardised by the Options Clearing Corporation and cannot be negotiated between buyer and seller — standardisation is what makes listed options liquid and interchangeable.

The underlying security is the stock, exchange-traded fund, or index on which the option is based. An option on Apple Inc. (AAPL) gives the holder rights related specifically to AAPL shares — no other security. Options exist on thousands of individual stocks, major ETFs including SPY, QQQ, and GLD, and broad market indices including the S&P 500 Index.

The option type is either a call or a put — the two fundamental categories that define what right the buyer holds and what obligation the seller assumes. Call options convey the right to buy. Put options convey the right to sell.

The strike price — also called the exercise price — is the fixed price per share at which the underlying security may be bought or sold if the option is exercised. 

A call with a fifty dollar strike price allows its holder to buy one hundred shares at fifty dollars per share regardless of the current market price. A put with a seventy dollar strike price allows its holder to sell one hundred shares at seventy dollars per share regardless of the current market price. 

Strike prices for standard equity options are set at intervals defined by OCC specifications — generally two dollar and fifty cent increments for strikes below twenty-five dollars, five dollar increments from twenty-five through two hundred dollars, and ten dollar increments above two hundred dollars.

The expiration date is the date on which the option expires and ceases to exist. For standard monthly equity options, expiration occurs on the third Friday of the expiration month at eleven fifty-nine PM Eastern Time. An option that is not exercised by the option holder before expiration becomes worthless and terminates automatically. Weekly options — introduced widely since 2005 — expire on Fridays other than the third Friday, providing shorter-duration contracts for specific trading strategies.

The Two Option Types — Calls and Puts

The call option and the put option are the two fundamental building blocks of all options strategies, and every options question on every securities licensing examination reduces to understanding what each type is, who holds rights and who holds obligations, and what market conditions make each profitable.

A call option gives the holder the right to buy the underlying security at the strike price at any time before expiration — in exchange for paying the premium. The call buyer is bullish — they expect the underlying security to rise above the strike price before expiration, at which point they can either exercise the call to buy shares below the prevailing market price or sell the call in the secondary market at a profit reflecting its increased intrinsic value. 

As confirmed by FINRA's options definition, a call is an options contract that conveys the right to buy the underlying security at a set price — the strike price — by a designated date — the expiration date. 

The seller of the call — the call writer — accepts the obligation to sell the underlying shares at the strike price if the holder exercises. The call writer's maximum gain is the premium collected. The call writer's loss is unlimited if the underlying price rises dramatically, because the writer must sell at the strike price regardless of how high the market price climbs.

A put option gives the holder the right to sell the underlying security at the strike price at any time before expiration — in exchange for paying the premium. The put buyer is bearish — they expect the underlying security to decline below the strike price before expiration, at which point they can either exercise the put to sell shares above the prevailing market price or sell the put at a profit in the secondary market. 

As confirmed by FINRA, a put is an options contract that conveys the right to sell the underlying security at a set price — the strike price — by a designated date. The put writer accepts the obligation to buy the underlying shares at the strike price if exercised, collecting the premium in exchange for this obligation.

The Premium — What Buyers Pay and Sellers Receive

The premium is the price of the option contract — the amount the buyer pays to the seller at the time of the transaction in exchange for the rights conveyed by the contract. As confirmed by FINRA's options resource, the premium is a nonrefundable payment in full from the purchaser to the seller in exchange for the rights conveyed by the option. If the option expires worthless — if the holder never exercises and allows it to expire — the seller keeps the entire premium as profit with no further obligation, and the buyer loses the entire premium as their maximum loss.

Premium is quoted on a per-share basis — a premium of three dollars means three dollars per share of the underlying security. Since every standard equity option contract covers one hundred shares, the total dollar cost of a contract with a three dollar premium is three hundred dollars. The one-hundred-share multiplier applies to all dollar calculations involving equity option premiums, gains, and losses.

The premium consists of two components — intrinsic value and time value. Intrinsic value is the amount by which the option is in the money — the immediate profit from exercising right now. For a call with a fifty dollar strike when the stock trades at fifty-six dollars, intrinsic value is six dollars. For an out-of-the-money or at-the-money option, intrinsic value is zero. 

Time value — also called extrinsic value — is the portion of the premium above intrinsic value, representing the market's pricing of the probability that the option will become or become more in the money before expiration. Time value decays toward zero as expiration approaches — a process called theta decay that accelerates in the final weeks before expiration. At expiration, time value is zero and the option is worth exactly its intrinsic value.

The OCC — The Issuer and Guarantor

The Options Clearing Corporation — the OCC — is the issuer of every standardised exchange-listed equity option in the United States securities markets. As confirmed by FINRA's SIE options curriculum, there is only one issuer for listed options — the OCC — regardless of who issued the underlying security. When McDonald's Corporation options trade on the CBOE, the OCC issues the option contract, not McDonald's. 

This means the OCC creates the standardised contract terms at issuance and guarantees performance of every contract — if the writer of an option fails to perform upon exercise, the OCC steps in to ensure the holder's rights are satisfied.

The OCC's guarantee function is what makes listed options credit-risk-free from the perspective of the option buyer. Because the OCC interposes itself as the counterparty to every transaction — becoming the buyer to every seller and the seller to every buyer — option buyers need not assess the creditworthiness of the specific individual who wrote their contract. 

The OCC's guarantee eliminates counterparty credit risk entirely for standardised exchange-listed options.

The OCC also functions as the clearinghouse for options markets — processing and settling all options transactions, maintaining records of all open positions, and managing the daily margin requirements for short option writers whose obligations create financial risk that must be collateralised.

American Versus European Style

All exchange-traded equity options in the United States are American-style options — the holder may exercise at any time from the purchase date through and including the expiration date, not only at expiration. As confirmed by the OCC's equity options product specifications and FINRA's assignment resources, American-style options may be exercised on any business day up to and including the expiration date, and exercise notices tendered on any business day result in delivery of the underlying stock on the first business day following exercise — T plus one settlement.

European-style options can only be exercised during a specified period immediately before expiration — typically only on the expiration date itself. 

In United States markets, European-style options apply primarily to broad market index options such as SPX options on the S&P 500 Index. ETF options — such as SPY options on the SPDR S&P 500 ETF — are American-style despite being based on S&P 500 exposure. The distinction between American and European style is directly tested on the Series 7 examination.

Opening and Closing Transactions

Every options transaction is classified as either an opening transaction or a closing transaction, and this classification governs whether the investor is establishing or eliminating a position.

An opening purchase establishes a long options position — the investor is buying options to create a new position. An opening sale establishes a short options position — the investor is selling options to create a new obligation. These are the two types of opening transactions.

A closing sale eliminates a long options position — the investor who previously bought options sells the same contract in the market, cancelling the position. 

A closing purchase eliminates a short options position — the investor who previously sold options buys the same contract in the market, cancelling the obligation. These are the two types of closing transactions.

The classification matters because the net position after each transaction — long or short, holder or writer — determines the investor's rights and obligations. 

An investor who executes a closing sale for a long call is exiting the position and surrendering their rights. An investor who executes a closing purchase for a short put is buying back their obligation and relieving themselves of the duty to purchase shares if assigned.

Options Account Approval and the Options Disclosure Document

Options trading is not available to all customers by default — it requires specific account approval. FINRA Rule 2360 requires member firms to exercise due diligence when opening options accounts to ensure suitability for the customer, and a Registered Options Principal or Limited Principal-General Securities Sales Supervisor must approve each options account in writing. 

Accounts approved for writing uncovered — naked — short options require additional ROP review given the elevated risk of theoretically unlimited loss on naked calls and substantial loss potential on naked puts.

Before an options account is approved, the firm must deliver the Options Disclosure Document — formally titled Characteristics and Risks of Standardized Options and commonly called the ODD — to the customer. 

The ODD is prepared by the OCC and provides a comprehensive description of the mechanics, characteristics, and risks of options trading. FINRA Rule 2360 defines the ODD as a comprehensive document outlining the mechanics, risks, and costs of options trading required to be delivered to all options customers before the account is approved. 

An SEC rule — Exchange Act Rule 9b-1 — requires that the ODD be delivered to customers before they begin trading options, making it one of the most important pre-account-opening disclosure documents in the securities industry.

Position and Exercise Limits

FINRA Rule 2360 establishes position limits — the maximum number of option contracts on the same side of the market in the same underlying security that any single entity or coordinated group may hold or control. Position limits vary by the option type and the size and liquidity of the underlying security, typically ranging from 25,000 to 250,000 contracts for standard equity options, with some highly liquid large-cap equity options exempt from specific numerical limits. Position limits prevent any single investor from accumulating an option position large enough to manipulate the underlying securities market.

Exercise limits restrict the number of option contracts of the same class that can be exercised within any five consecutive business days. Exercise limits correspond to position limits — an investor who cannot hold more than 250,000 contracts cannot exercise more than 250,000 contracts in any five-day period.

Settlement of Options Transactions

Options contract trades settle in one business day — T plus one — as confirmed by both the OCC product specifications and FINRA's curriculum resources. This settlement cycle applies to the options trade itself — the payment of premium between buyer and seller.

If an equity option is exercised, a separate stock transaction occurs. The underlying stock transaction resulting from exercise settles on the normal equity settlement cycle of T plus one under current United States equity settlement rules, effective May 28, 2024, when the SEC moved the standard settlement cycle from T plus two to T plus one under amendments to Exchange Act Rule 15c6-1.

Examination Relevance and Key Takeaways

Options are tested extensively on the SIE, Series 7, and Series 65 examinations covering the fundamentals of contract structure, the four defining terms, the distinction between calls and puts, buyers and sellers, premium components, American versus European style, opening and closing transactions, and account approval requirements.

The key points to retain are these.

An option gives the buyer the right — but not the obligation — to buy or sell the underlying security at the strike price before expiration in exchange for a premium paid to the seller who accepts the corresponding obligation. The four defining terms of every standardised option contract are the underlying security, the option type — call or put — the strike price, and the expiration date. 

A call conveys the right to buy — the buyer is bullish. A put conveys the right to sell — the buyer is bearish. The premium is the price of the contract quoted per share — multiply by one hundred to get the total contract dollar value. 

The premium equals intrinsic value plus time value — time value decays to zero at expiration. The OCC is the issuer and guarantor of all standardised exchange-listed equity options — one issuer regardless of the underlying company — and acts as the central counterparty eliminating credit risk. 

All exchange-traded equity options in the United States are American-style — exercisable any business day through expiration — while most broad index options are European-style — exercisable only at expiration. Options trades settle T plus one. Exercise of equity options results in a stock transaction settling T plus one. 

Options account approval requires delivery of the ODD — Characteristics and Risks of Standardized Options — before trading begins per Exchange Act Rule 9b-1. Position limits under FINRA Rule 2360 restrict the maximum contracts any entity may hold on the same side of the market in the same underlying security.