Calls And Puts
There are two types of options: a "call" and a "put." The relationship between owners and sellers is asymmetrical, as the ownership confers the right of exercise, whereas a sale confers the obligation to deliver the underlying item upon exercise by the owner.

  • A call permits the owner (who is long the call) to buy an underlying good at a specified exercise price (strike price) within a certain period.
  • A call requires the seller (who is short the call) to deliver the underlying good when the call holder exercises the call
  • A put permits the owner to sell the underlying commodity at a specified exercise price within a certain period.
  • A put requires the seller (who is short the put) to purchase the underlying good when the owner of the put exercises his or her right to sell that good at the strike price.

Options, as well as options on futures, are exchange traded and are issued by the clearinghouse on the exchange where they are traded. Both exercise prices and expiration dates are standardized. Exercise settlement choices for options on futures may be

  • American Style – the holder may exercise at any time up to the last day before the contract expires.
  • European Style – the holder of the option may exercise only during a short window just prior to expiration (one to five business days).
Position Occurrence Underlying Good Received
Long Call Holder exercises Long Futures Position
Short Call Holder of the long call exercises. Short Futures Position
Long Put Holder Exercises Short Futures Position
Short Put Holder of the long put exercises. Long Futures Position

Choices Available To Owners Of Calls And Puts

    1. Exercise the option: the owner of the call or put may exercise the option if it would be profitable to do so.
      • Call Option
        • In the Money – if the market price of the underlying exceeds the exercise (strike) price, the option is in the money as the owner may purchase at the strike price for less than the price at which the underlying trades and sell it for a profit.
        • At the Money – the market price of the underlying equals the exercise price. Exercise would not be prudent.
        • Out of the Money – the market price of the underlying is lower than the strike price. Exercise would be imprudent as the investor could purchase shares in the open market for less than the strike price.
      • Put Option
        • In the Money – if the market price of the underlying is lower than the exercise (strike) price, the option is in the money as the owner may sell the underlying for more than its market price.
        • At the Money - the market price of the underlying equals the exercise price. Exercise would not be prudent.
        • Out of the Money – the market price of the underlying is higher than the strike price. Exercise would be imprudent as the investor would be sell shares for the strike price which is less than what he would receive in the market.
    2. Allow the option to expire: the purchase of an option is akin to the purchase of insurance. With call and puts, respectively, the owner has paid a premium for the right of exercise. Market conditions may not warrant exercising the option, in which case, allowing expiry would be a choice.
    3. Trade (sell) the option: based on his or her research of the underlying, the trader may determine that the option will remain at or out of the money, in which case he or she elects to sell the option. Indeed, the option's premium is a function of the fundamentals of the underlying good. The holder of the option could trade it even if it is in the money. Trading options, rather than the underlying, is a cost effective way to tailor market exposure to an investor's needs and circumstances.

A Brief Note on Options Valuation: a robust treatment of the pricing of options is beyond the scope of the Series 3 exam. However, the test may ask the candidate to demonstrate his or her knowledge of a few basic concepts.

Intrinsic Value: an option's intrinsic value is the extent to which it is in the money. For example, if a call option's strike price is $43 on the underlying and price of the underlying is $48, then that option is in the money and its intrinsic value is $5 ($48-$43). If a put option's strike price is $32 on the underlying and the price of the underlying itself is $29, then that option is in the money and its intrinsic value is $3 ($32-$29).

Time Value: an option's time value is any amount over its intrinsic value. Drawing on the previous examples and holding all else constant, a value on the call option of $7 would consist of its time value $48-$43 = $5 plus its time value of $2. For the put, suppose its value is $6. The intrinsic value is $3 ($32-$29) and the time value is $3. Time value decreases as the option approaches expiration.

One's view of the market may dictate his or her options strategy.


      • The maximum gain of a long call and the maximum loss on a short call are unlimited.
      • On long calls and puts the maximum loss is the premium paid.
    1. Enter a closing (offsetting) transaction. The following table summarizes the transactions required to offset a transaction.
Transaction Open Close
Holders Buy Sell
Writers (sellers) Sell Buy

Our examples in this chapter treat stock options trading on the CBOE. Listed stock options have the benefit of being standardized in terms of:

    • number of shares of underlying common stock,
    • delivery dates, and
    • range of exercise prices.

For example, a trader believes that the common stock of XYZ, now trading at $20 per share, will experience a fifty% decline in the next two months. The trader in this scenario does not own the common shares. Instead, he purchases a put giving him the right to sell 10,000 shares at $18 per share. Continuing the fact pattern, the share price declines to $10. The trader now purchases 10,000 shares on the open market at $10 each and sells them for $18 to the seller of the put. He has just earned $80,000 ($8 per share times $10,000), before transaction costs.

In this example, the put holder did not own the underlying stock. Sometimes puts are purchased by investors who own significant amounts of a company's stock as a protective hedge against a catastrophic drop in share price. In this case, the put owner would already have the shares to sell, rather than having to purchase them in the open market. The put would be covered. In the previous scenario, the trader wrote an uncovered put.

Taking Positions
The seller of an option is the "writer." An "opening transaction" occurs whenever a writer sells an option to a buyer. An opening transaction has the effect of creating a "long position," in which a party will pay for and receive the option, and an offsetting "short position," in which a party takes payment for and writes the option.

On the Series 3 exam, "long" refers to a purchase of the option and "short" refers to its sale.


The Series 3 exam is likely to ask a question that requires the candidate to identify positions that subject the trader to unlimited losses. For example, option writing is speculative as the seller may assume unlimited risk from the buyer, particularly if the calls are uncovered.

The Series 3 exam may well test a candidate's knowledge of the benefits of taking long option positions, namely that they increase leverage while mitigating risk.

Risk Management Using Options

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