The same listed option can insure a retiree's stock against a crash or turn a $200 bet into a total loss within a month. Which one you are recommending depends on the side of the contract your client takes and on what the client already owns.
An option gives its buyer a right and gives its seller an obligation. Four terms carry everything that follows:
- Call: The buyer may buy 100 shares at a fixed strike price until expiration.
- Put: The buyer may sell 100 shares at the strike price until expiration.
- Premium: This is the buyer's price. It is quoted per share, so a $3 premium costs $300 per contract.
- Writer: This is the seller. The writer keeps the premium and must sell (on a call) or buy (on a put) if the buyer chooses to exercise.
The premium has two layers. Intrinsic value is the amount by which an option is in the money.
Option breakevens and maximum results both follow from who holds the right. The breakeven is the stock price at expiration where the position neither makes nor loses money.
Common mistakes
- Floor price as maximum loss: Ana's $52 in Example 1 is her floor price. Her maximum loss is $8 a share ($800), which is cost minus strike plus premium.
- Strike minus premium on a short call: Writers share the buyer's breakeven (see the HIGH-FREQUENCY note).
- A farmer buying futures: A producer fears falling prices, so she sells futures. Buying futures is the user's long hedge.
Bottom line
- Breakevens: calls break even at strike plus premium and puts at strike minus premium, for buyer and writer alike.
- Option buyers risk only the premium; uncovered call writers face unlimited loss; uncovered put writers risk strike minus premium.
- Protective put: floor is strike minus premium, maximum loss is cost minus strike plus premium, and breakeven is cost plus premium.
- A collar adds a short call to the protective put, limiting both loss and gain at low net cost.
Exam shortcut
Work every option stem in the same order. First, identify the client's side. A buyer's worst case is always the premium, so any answer showing a buyer losing more is wrong. Second, for a breakeven on a single option, look only at the option type: calls add the premium and puts subtract it, whoever wrote them. Third, for stock-plus-option positions, start at the stock cost.
The full lesson (about 3,747 words, 25 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- B15
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