Options

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.

Position Limits — Which Positions Count Against One Limit

A position limit applies to an account's positions on one side of the market taken together, and a long call and a short put are on the same side of the market because each of them gains value when the underlying security rises. An account that is long 20,000 call contracts on a security whose applicable position limit is 25,000 contracts may therefore be short no more than 5,000 put contracts on that same security, because the long calls and the short puts are added together against that single limit. The mirror arithmetic governs the other side: short calls and long puts on one security are added together against their own limit, so an account short 20,000 calls may be long no more than 5,000 puts.

Positions on opposite sides of the market are not added together at all. A customer who is long 25,000 call contracts on a security may at the same time be short 25,000 call contracts on it, because a long position and a short position in the same class of options sit on opposite sides and are not aggregated for this purpose. For the same reason a customer may be long 25,000 calls and long 25,000 puts on one security without approaching a breach, since a long call and a long put are on opposite sides of the market even though both are long positions.

The limit bites at the opening transaction rather than only on the position that results. Except in highly unusual circumstances and with FINRA's prior written approval for good cause shown in each instance, no member may effect an opening transaction in a class of stock options for an account in which the member has an interest, for the account of a partner, officer, director or employee, or for a customer's account, where the member has reason to believe that as a result of the transaction the person would — acting alone or in concert with others, directly or indirectly — hold, control or be obligated in respect of a position above the applicable limit. The prohibition runs against the member effecting the trade, so the firm has to form a view about the resulting aggregate position before the order is entered rather than reconcile it afterwards.

The Hedge Exemption — What a Stock Position Changes

Certain fully hedged pairings are exempt from the position limits that apply to standardised options, and each exempt option contract has to be hedged or covered by one hundred shares of the underlying security — or, where the contract has been adjusted, by the number of shares the adjusted contract represents. The qualifying one-for-one pairings are a long call against short stock, a short call against long stock, a long put against long stock and a short put against short stock. Securities convertible into the underlying security count for this purpose in the same way as the underlying itself.

The exemption is additive to the limit rather than a substitute for it. An account that is short 2,000,000 shares of a security whose position limit is 25,000 contracts may be long up to 45,000 call contracts on that security: 25,000 of them are permitted by the basic limit, and the remaining 20,000 are permitted because 2,000,000 shares divided by the one hundred shares a contract covers hedges exactly 20,000 contracts. An account holding no stock at all in the same security would breach the limit at 25,001 contracts.

Running the same hedge in conventional options instead of standardised ones does not produce an exemption. A qualified hedge strategy of the kinds described above, carried out in conventional options, is subject to a position limit of five times the established limit rather than being exempt from it, and the same five-times treatment applies to a back-to-back pairing of a listed option with an over-the-counter option and to a conversion, reverse conversion, collar or reverse collar in which one of the option components is a conventional option. A position limit established under the hedge provisions is separate from the limits established elsewhere in the rule.

How Many Contracts a Position Counts As

For the purposes of the position-limit and exercise-limit provisions, an option to purchase or sell common stock is deemed to cover one hundred shares at the time the contract granting it is written, and an option written over some other number of shares counts as as many contracts as that number divided by one hundred. An option granted over five hundred shares is therefore five option contracts against the limit, not one, and an account holding ten such options holds fifty contracts for limit purposes.

A contract that covered one hundred shares when it was written continues to count as one contract throughout its life for those same provisions, even though the number of shares it covers may be adjusted under its terms to reflect a stock dividend, a stock split, a reverse split or a similar action by the issuer of the underlying stock. The adjustment changes what the contract delivers; it does not change how many contracts the holder is treated as holding against the limit.

The aggregate exercise price of an option contract is its exercise price multiplied by the number of units of the underlying security the contract covers, which is what makes the effect of an adjustment easy to check. A call with a fifty dollar exercise price over one hundred shares has an aggregate exercise price of five thousand dollars, because one hundred multiplied by fifty dollars is five thousand dollars. If an adjustment doubles the shares the contract covers to two hundred and the exercise price becomes twenty-five dollars, the aggregate exercise price is two hundred multiplied by twenty-five dollars, which is the same five thousand dollars.

Which Option Positions Are Aggregated With Which

Standardised equity option contracts of the put class and the call class on one side of the market overlying a security are not aggregated with conventional equity option contracts or FLEX Equity Option contracts overlying the same security on the same side of the market. The two sets run against separate limits, so an account can hold a full standardised position and a conventional position in options on one security without the two being added together.

Index option contracts are not aggregated with option contracts on any of the stocks whose prices are the basis for the calculation of the index. An account holding index options and options on the individual component stocks is therefore measured against the index option limit and the single-stock limits separately rather than against one combined figure.

Where a conventional option is written on an exchange-traded fund that the rule does not list by name and that does not also underlie a standardised option, the position limit is the basic limit of 25,000 contracts. A member wanting a higher limit than that has to apply for one, demonstrating to FINRA's Market Regulation Department that the underlying security meets the standards for the higher limit and the initial listing standards for standardised options trading.

When Two Accounts Are Treated as One

Control, for the purposes of aggregating option positions, means the power or ability of an individual or entity to make investment decisions for an account or to influence those decisions directly or indirectly, and the rule presumes it in several relationships. Control is presumed among all parties to a joint account who have authority to act on behalf of the account, among all general partners to a partnership account, where accounts have common directors or management, and wherever a person or entity has authority to execute transactions in an account. Two accounts that are presumed to be under common control hold one aggregate position between them for limit purposes however separately they are traded.

Control is also presumed from economic interest set at a specific level: where a person or entity holds an ownership interest of ten percent or more in an entity, or shares in ten percent or more of the profits or losses of an account. An ownership interest below ten percent does not preclude aggregation, so an interest of eight percent leaves aggregation open to be established on the facts rather than settling the question in the holder's favour.

A presumption of control is rebuttable rather than conclusive. It can be rebutted by proving that the factor giving rise to it does not exist, or by showing other factors that negate the presumption, and the rebuttal proof has to be submitted by affidavit or such other evidence as is appropriate in the circumstances. The burden therefore sits with the person asserting that two accounts are independent, not with the regulator asserting that they are not.

Covered and Uncovered Short Option Positions

A short call position is covered where the writer holds, in the same account as the short position and on a unit-for-unit basis, a long position in an option contract of the same class whose exercise price is equal to or less than the exercise price of the short call. A long call struck at forty-five dollars covers a short call struck at fifty dollars on the same security, because the long call can be exercised to acquire the shares the short call must deliver at a price no higher than the strike the writer will receive.

A short put position is covered where the writer holds, in the same account and on a unit-for-unit basis, a long position in an option contract of the same class whose exercise price is equal to or greater than the exercise price of the short put. A long put struck at fifty-five dollars covers a short put struck at fifty dollars, because the long put can be exercised to dispose of the shares the writer is obliged to buy at a price no lower than the strike the writer will pay.

Uncovered, in respect of a short option position, means simply that the short position is not covered, and for the account-opening, account-supervision and disclosure-delivery provisions the phrase "writing uncovered short option positions" takes in combinations and any other transactions that involve uncovered writing. A multi-leg position is therefore treated as uncovered writing for approval and supervision purposes if any leg of it involves writing that is not covered, which is why a customer approved only for covered writing cannot reach the same economics by assembling the position out of several orders.

Reporting Large Option Positions

A member has to file a report with FINRA for each account — its own, an account of a partner, officer, director or employee, or a customer, non-member broker or non-member dealer account — which, acting alone or in concert, has established an aggregate position of 200 or more conventional option contracts of the put class and the call class on the same side of the market covering one underlying security. The same side-of-the-market convention that governs the limits governs the count, long put positions being combined with short call positions and short put positions with long call positions. The threshold is far below any position limit, so an account can be fully reportable while nowhere near a breach.

The report has to identify the person or persons having an interest in the account and to identify separately the total number of option contracts of each class making up the reportable position, in the form FINRA prescribes. A single aggregate number for the account does not satisfy the requirement.

Separately from those periodic reports, a member has to report promptly to FINRA any instance in which it has reason to believe that a person, acting alone or in concert with others, has exceeded or is attempting to exceed a position limit or an exercise limit. The duty is triggered by the member's reasonable belief and it reaches an attempt, so it can arise before any limit has in fact been breached.

What FINRA May Direct When a Limit Is Exceeded

Where FINRA determines that a person or a group of persons acting in concert holds, controls or is obligated in respect of an aggregate position above the position limits, and determines that action is necessary or appropriate in the public interest and for the protection of investors, it may direct any member or all members carrying the position for that person to liquidate the position or a portion of it as expeditiously as possible and consistent with the maintenance of an orderly market, so as to bring the person into compliance. The directive is addressed to the members carrying the position rather than to the customer who built it.

FINRA may instead, or in addition, direct that the named person not be permitted to execute an opening transaction and that no member accept or execute an order for an opening transaction in any option contract for that person. A directive of that kind can be displaced in any instance by FINRA's express approval, it falls away if the directive is rescinded, and the directive itself may specify another restriction appropriate to the circumstances instead.

Before issuing either directive FINRA has to notify the person or group, in the most expeditious manner possible, of the action, of the specific grounds for it and of the opportunity to be heard on it. Absent unusual circumstances, the hearing on a liquidation directive is held within one business day of the notice, a record is kept of the proceeding, and a determination to implement the directive is made in writing and supported by a statement of the specific grounds on which it is based.

Restrictions on Transactions and on Exercise

FINRA may impose restrictions from time to time on option transactions, or on the exercise of option contracts, in one or more series of any class where it determines the restriction is necessary to maintain a fair and orderly market in the option contracts or in the underlying securities, or is otherwise necessary in the public interest or for the protection of investors. While such a restriction is in force no member may effect an option transaction or exercise an option contract in contravention of it.

A restriction on exercise has a fixed end. During the ten business days before the expiration date of a given series of options, no restriction imposed under that provision on the exercise of option contracts remains in effect with respect to that series. A holder of an expiring series therefore reaches the final stretch of the contract's life with the exercise right unrestricted by any such measure, whatever market condition prompted it.

A separate power addresses uncovered writing rather than exercise. Where FINRA determines, in the light of conditions in the options markets or in the markets for the underlying securities, that the number of uncovered short positions outstanding in a class of option contracts exceeds the limits it has established, or that the percentage of outstanding short positions in that class which are uncovered exceeds those limits, it may prohibit further opening writing transactions in that class unless the resulting short position will be covered, and it may prohibit the uncovering of an existing covered short position in one or more series of the class.

The Issuer's Own Account, Restricted Stock and Transfer Taxes

No member may enter a transaction for the sale — the writing — of a call option contract for the account of a corporation that is the issuer of the underlying security of that call. The prohibition is absolute in its terms and turns on the identity of the account holder rather than on the size of the position or the suitability of the strategy.

Where shares of an underlying stock may not be sold by their holder except on registration under the Securities Act or under an SEC rule promulgated under it, no member may accept those shares for the purpose of covering a short call position, of making delivery on the exercise of a put, or of satisfying an exercise notice assigned in respect of a call, unless the applicable provisions of the Securities Act and the rules under it have been complied with by the holder. Compliance has to hold both at the time the securities are accepted and at any later time they are delivered.

A stock transfer or similar tax payable on the sale, transfer or delivery of securities on the exercise of an option falls on different parties for calls and for puts. On a call it is the responsibility of the seller — the writer — to whom the exercise notice is assigned; on a put it is the responsibility of the exercising holder. Each side of that default shifts where the incidents of the tax are attributable solely to the other party or to the member representing it.

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.