A customer owns 100 shares of stock at $50 and worries about a short-term drop. Should she buy a put or write a covered call? Should her retirement money go into Class A shares with a breakpoint or Class C shares with higher 12b-1 fees? Two product families, two completely different risk profiles, and the SIE expects you to map customer to product cleanly.
An option is a contract giving the buyer the right, not the obligation, to transact in an underlying security at a fixed price within a set time. Four building blocks define every option:
- Strike (exercise) price: the locked-in transaction price.
- Premium: what the buyer pays the seller for the contract. Premium is the maximum loss for any option buyer.
- Expiration: standard listed equity options expire the third Friday of the expiration month.
- Contract size: one equity option contract represents 100 shares. A premium quoted as 3.50 means total cost $350.
Two contract types:
- Call: right to buy the underlying at the strike. Call buyers are bullish (want price up). Call writers are bearish or neutral.
- Put: right to sell the underlying at the strike. Put buyers are bearish (want price down). Put writers are bullish or neutral.
Common mistakes
- Treating the option premium as the contract cost without multiplying by 100. A 3.50 premium = $350 per contract, not $3.50.
- Assuming all option writers face unlimited loss. Only the naked call writer (and short stock) does. Naked puts are bounded by the strike.
- Confusing closed-end funds with mutual funds. Closed-end funds trade intraday at market price and can sell at a premium or discount to NAV; mutual funds always price at NAV after the 4:00 p.m. close.
Bottom line
- One equity option = 100 shares; premium quoted per share, total cost = premium × 100
- Call buyer profits when price rises above strike + premium; put buyer profits when price falls below strike − premium
- Naked call writers and short stock have unlimited loss potential; a covered call caps gain at strike + premium received
- Index options settle in cash with a $100 multiplier; equity options deliver 100 shares
Exam shortcut
Premium math: contract price × 100 for equity, × $100 multiplier for index. Same number, different label. "Unlimited loss" answer choice is correct only for naked call or short stock. Anything else, eliminate it. "Trades intraday at a discount to NAV" = closed-end fund. "Redeemed at next-calculated NAV" = open-end fund or UIT.
The full lesson (about 2,940 words, 20 min read) adds 2 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- B7
- B8
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