Options Fundamentals and Contract Specifications
Domain 1 - Options Fundamentals and Contract Specifications
This domain tests whether you can describe a listed option contract precisely: what the holder owns, what the writer owes, how the contract is standardized, and how it is adjusted or settled when the underlying changes.
Contract anatomy
- One standard equity option covers 100 shares. The premium is quoted per share, so a $3.40 quote costs $340 per contract.
- The buyer (holder) has a right; the writer has an obligation secured by margin. The counterparty to every trade is the OCC, not the issuing company, so holder counterparty risk is minimal.
- Equity and ETF options are American-style (exercise any time before expiration); broad-based index options such as SPX are European-style and cash-settled.
- Standard expiration is the third Friday of the month, which is also the last trading day for equity options.
- Strikes are set in intervals that widen as the underlying price rises, and OCC adjusts the deliverable for splits, spinoffs, and special dividends (e.g., a 2:1 split makes one contract deliver 200 shares at half the strike).
Worked example
An investor buys 3 XYZ June 45 calls at $2.10 when XYZ trades at $44. Cost = 3 × 100 × $2.10 = $630. At expiration XYZ is $49. Exercise value = 3 × 100 × ($49 − $45) = $1,200; net profit $570. Below $45 the entire $630 is lost; breakeven is $47.10.
Traps
- Confusing the premium received by a call writer (a credit that caps gain) with the buyer's debit.
- Forgetting that assignment is allocated randomly among writers who are short, not necessarily the original writer.
- Assuming a contract always settles in 100 shares after a corporate action.
- Missing that exercise notices are due to the broker by its own cutoff, typically well before the OCC deadline.