Calls and puts: rights versus obligations

One contract, two very unequal sides

An option is a contract over a security, usually 100 shares of stock. One side buys and one side writes. The buyer pays a premium and receives a right; the writer receives that premium and takes on an obligation. The right can be abandoned and the obligation cannot, and almost every options question on the exam is testing whether you have kept those two words apart.

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.

Exam terms

Option

A contract that gives its buyer the right, but not the duty, to buy (a call) or sell (a put) the underlying at the strike price. The writer takes the matching obligation. Index options settle in cash instead.

Underlying

What an option is based on, such as the shares of a stock or ETF, or the value of an index.

Call

The right to buy the underlying at the strike price until expiration.

Put

The right to sell the underlying at the strike price until expiration.

Premium

What the buyer pays and the writer receives for the contract.

Strike price

The fixed price at which the option may be exercised.

Writer

The party who sells the contract and takes the obligation.

Options Clearing Corporation

Issues listed options and guarantees performance to both sides.

American-style

Exercisable at any time prior to expiration.

European-style

Exercisable only during a specified period before expiry; in practice, only on the expiration date.

Physical delivery option

Exercise moves the underlying interest itself.

Cash-settled option

Exercise pays the difference between the exercise settlement value and the exercise price.

Multiplier

What one point is worth. At 100, a $4 premium is $400 for the contract.

Worked example

A stock trades at $48. One investor buys a 50 call for a premium of $3 a share; another writes that same contract.

1. The contract covers 100 shares, so the buyer pays $300 and the writer receives $300 immediately.
2. The stock finishes at $46. Buying at $50 is worse than buying in the market, so the buyer abandons the right and the contract expires worthless.
3. The buyer’s loss is the $300 premium and nothing more; the writer’s gain is that same $300, which was the best the writer could ever do.
4. Now run it again with the stock at $58. The buyer exercises the right to buy at $50 and the writer must deliver 100 shares at $50, buying them at $58 if they are not already owned.
5. That second run is the whole asymmetry. The buyer risked $300 and gained $800 before the premium; the writer collected $300 and lost $800 before it; for a writer who did not own the shares, nothing capped how much worse it could have been.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• Call vs put, buyer vs writerPractice this