Calls and puts: rights versus obligations

A call is the right to buy at the strike price. A call buyer wants the stock to rise, because buying at a fixed price is worth having only when the market price is above it. A put is the right to sell at the strike price. A put buyer wants the stock to fall, because selling at a fixed price is worth having only when the market price is below it.

The writer is the mirror image and is never given a choice. A call writer must deliver the shares at the strike if the buyer exercises; a put writer must buy the shares at the strike if the buyer exercises. The writer’s best outcome is that the option is never exercised and the premium is kept, which is why writing is a strategy for expecting the market not to move against the position.

Behind every listed option stands the Options Clearing Corporation. It issues the contracts, and through novation it becomes the buyer for every seller and the seller for every buyer, so a buyer exercising does not need to find the person who wrote the contract. As guarantor it ensures that the obligations of the contracts it clears are fulfilled.

Two standardized terms decide questions that otherwise look identical. The first is style, which is simply when the option may be exercised. An American-style option may be exercised at any time prior to expiration. A European-style option may be exercised only during a specified period before it expires, and every European-style option trading at the date of the disclosure document is exercisable only on its expiration date. The options disclosure document names a third style, capped, and when a European-style or capped option cannot be exercised, the holder’s only way to realize a profit or loss is to sell it in a closing transaction. Style says nothing about where the option trades or who may buy it — a European-style option is not European.

The second is how the contract settles. A physical delivery option hands over the underlying interest: exercise a call and the holder receives the shares, exercise a put and the holder delivers them. A cash-settled option pays a cash difference instead — the amount by which the exercise settlement value, the determined value of the underlying at exercise, exceeds the exercise price for a call, or falls short of it for a put. Index options work this way for the obvious reason that nobody can deliver an index. The size of the payment, and of the premium, comes from the multiplier that the options market fixes for the series. A multiplier of 100 means every point in the money adds $100 to the settlement, and it means a quoted premium of $4 costs $400 for one contract. The same arithmetic applies to a stock option: an XYZ 40 call is the right to buy 100 shares at $40, an aggregate exercise price of $4,000.

Put the two settlement methods side by side, because a question may depend on that difference alone. Exercising a physical delivery call means paying the strike price and receiving the underlying shares; exercising a physical delivery put means delivering the shares and receiving the strike price. Exercising a cash-settled option moves no shares at all: the holder receives cash equal to the amount by which the option is in the money, multiplied by the contract multiplier. Options on individual stocks are generally physical delivery. Options on an index are cash-settled, because there is no single security to deliver.