An option buyer can never lose more than the price paid, while an uncovered call writer can lose without limit. Those two people hold opposite sides of the same contract. That is why options carry their own disclosure document, their own account approval and a steady share of exam questions.
An option is a contract that gives one party a right, for a limited time, to buy or sell an underlying asset at a fixed price. The other party takes on the matching obligation. Because a buyer can lose the whole premium and an uncovered writer can lose without limit, the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization for broker-dealers, defines each term precisely in Rule 2360. Each option has two sides, and options come in two types, calls and puts:
- Holder: The buyer is long the option. The holder pays the premium and decides whether to use the right.
- Writer: The seller is short the option. The writer receives the premium and must perform if the holder exercises.
Common mistakes
- Reversing the put test: A put is in the money when the market is below the strike. With XYZ at $55, a 50 put is out of the money, not in the money by 5.
- Dropping the cost basis on a covered call: For stock bought at 48 with a 55 call written at 2, the maximum gain is $900. It is not 55 + 2 = 57 per share.
- Calling a cash-secured put covered: Under Rule 2360(a)(10), only a long put of the same class with an equal or higher strike covers a short put.
Bottom line
- Calls give the holder the right to buy and puts the right to sell; holders pay the premium and hold rights, writers receive it and carry obligations; one equity contract covers 100 shares.
- A call is in the money when the market is above the strike, a put when it is below; premium equals intrinsic value plus time value, and moneyness ignores premium.
- A buyer's maximum loss is the premium and a writer's maximum gain is the premium; call breakeven is strike plus premium, put breakeven is strike minus premium.
- Covered call maximum gain is strike minus cost plus premium and breakeven is cost minus premium; uncovered call writers face unlimited loss, and put writers lose at most strike minus premium.
Exam shortcut
Sort every strategy stem first: buyer or writer, call or put, with or without stock. Write the breakeven before anything else. For calls, add the premium to the strike. For puts, subtract it. Positions that include stock start from cost basis. The buyer's worst case and the writer's best case are always the premium, so look for that number among the choices.
The full lesson (about 4,806 words, 32 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- B7
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