Stock option contracts are exchange-traded agreements that give the buyer the right, but not the obligation, to buy or sell 100 shares of a specific stock at a fixed price before a set deadline. The buyer pays a non-refundable premium for that right. The seller (called the writer) collects the premium and takes on the matching obligation to deliver or purchase shares if the buyer decides to act. Every standard U.S. equity option covers 100 shares, trades under Securities and Exchange Commission oversight, and clears through the Options Clearing Corporation, which guarantees performance on both sides of the trade.1The Options Clearing Corporation. Clearance and Settlement
The Four Terms That Define Every Contract
Before a trade can be recorded on the exchange, four things have to be locked in.
The underlying security is the specific stock the contract is tied to. Its price movement is what makes the contract gain or lose value.
The strike price is the fixed dollar amount at which the shares can be bought or sold if the contract is used. It doesn’t change once the trade is made, no matter what the stock does.
The expiration date is the deadline for acting. Standard monthly options expire on the third Friday of the contract month. Weekly options expire every Friday. Long-term contracts called LEAPS (Long-Term Equity Anticipation Securities) can run out to roughly three years from the initial listing, with January-only expirations.2Cboe Global Markets. Equity LEAPS Options Product Specifications
The premium is what the buyer pays the seller for the rights the contract carries. Premiums are quoted per share, so a $3.00 premium costs $300 for one contract of 100 shares. If you buy the contract and never use it, that premium is the most you can lose.
Calls and Puts: The Two Basic Types
A call option gives the buyer the right to purchase 100 shares at the strike price. If you hold a call with a $50 strike and the stock climbs to $80, you can still buy at $50. Your profit is the difference between the market price and the strike, minus what you paid in premium. If the stock never rises above the strike, you let the contract expire and lose only the premium.
Leverage is the draw. Buying 100 shares of a $50 stock costs $5,000. A call on those same shares might run $300. You control the same position for a fraction of the capital, with the trade-off that the contract goes to zero if the stock doesn’t move in time.
A put option works in reverse. It gives the buyer the right to sell 100 shares at the strike price. If you hold a put with a $60 strike and the stock drops to $35, you can still sell at $60. Puts are commonly used to protect stock you already own: if you bought shares at $100 and want a floor, buying a put with a $95 strike guarantees you can sell at $95 no matter how far the stock falls. Compared with a stop-loss order, a put won’t get triggered by a brief intraday swing and lock you out of a recovery.
Buyer vs. Writer: Rights on One Side, Obligations on the Other
Every option contract is asymmetric. The buyer has rights and no obligations. The writer has obligations and collects the premium up front.
As a buyer, you decide whether to exercise. If the trade moves against you, your loss is capped at the premium you paid.
The writer’s picture is different. A call writer has to deliver shares at the strike price if assigned. A put writer has to buy shares at the strike price. Brokerages enforce this by requiring writers to post margin collateral, which can run into thousands of dollars in cash or securities depending on the position.3FINRA. FINRA Rules – 4210 Margin Requirements Writers who fail to meet margin or delivery obligations face forced liquidation and potential FINRA disciplinary action.
Covered Calls vs. Naked Calls
A call writer’s risk depends entirely on whether they already own the shares. A covered call writer owns the 100 shares and agrees to sell them at the strike price if assigned. The worst outcome is being forced to sell at a price below the current market, which caps upside but doesn’t create runaway exposure.
A naked call writer doesn’t own the shares. If the stock surges and the buyer exercises, the writer has to go buy shares at the current market price and deliver them at the lower strike. Because a stock can theoretically rise without limit, naked calls carry unlimited loss potential. Brokerages restrict naked call writing to their highest options approval level and impose steep margin requirements.3FINRA. FINRA Rules – 4210 Margin Requirements
Early Assignment
Most U.S. equity options are American-style, meaning the buyer can exercise at any point before expiration. Index options like those on the S&P 500 are typically European-style and can only be exercised on the expiration date itself. For writers, the American style means you can be assigned any day the market is open, not just at expiration.
Early assignment shows up most often in one specific setup: a call you wrote is deep in the money right before the stock’s ex-dividend date. The holder has an incentive to exercise early to own the shares in time for the dividend. If the option’s remaining time value is less than the upcoming dividend, early exercise becomes almost certain. Writers who aren’t watching can wake up short shares or scrambling to cover.
Exercise, Assignment, and Settlement
When a buyer decides to exercise, the instruction goes to the broker and then to the Options Clearing Corporation. The OCC assigns the exercise to a clearing member, and that firm passes it down to an individual writer’s account.4The Options Clearing Corporation. Standard Assignment Procedures
Settlement depends on what the contract is written on. Equity options on individual stocks and ETFs use physical delivery: actual shares change hands. Exercise a call on Apple and 100 shares of Apple land in your account. Index options are cash-settled, because you can’t deliver shares of an index. The OCC calculates the difference between the strike and the settlement value, applies the contract multiplier, and moves money.5Cboe Global Markets. Why Option Settlement Style Matters Since May 2024, U.S. securities transactions settle on a T+1 basis, so the actual transfer of shares or cash finalizes one business day after exercise.6U.S. Securities and Exchange Commission. SEC Chair Gensler Statement on Upcoming Implementation of T Plus 1
Automatic Exercise at Expiration
One point that catches newer traders: an in-the-money option at expiration doesn’t require you to do anything to get exercised. The OCC’s “exercise by exception” procedure automatically exercises any expiring option that finishes at least $0.01 in the money unless you tell your broker otherwise.7U.S. Securities and Exchange Commission. Rule 1100 – Exercise of Options Contracts Hold a call with a $50 strike into a $50.01 close on expiration Friday and you’ll receive 100 shares whether you wanted them or not.
To block automatic exercise, you submit a “contrary exercise advice” through your broker. The general deadline for final exercise instructions is 5:30 p.m. Eastern Time on the business day before expiration, and brokers have until 7:30 p.m. Eastern to pass contrary instructions to the exchange on behalf of customer accounts.7U.S. Securities and Exchange Commission. Rule 1100 – Exercise of Options Contracts Contact your broker well before those cutoffs if you don’t want an expiring in-the-money contract exercised.
Getting Approved to Trade Options
You can’t open a brokerage account and start selling naked calls. Brokerages assign options approval levels based on your trading experience, income, net worth, and stated objectives. Exact labels vary, but most firms use a four-tier structure:
- Level 1 covers covered calls and cash-secured puts. You either own the underlying shares or hold enough cash to buy them if assigned. This is the entry point for most investors.
- Level 2 covers buying calls and puts outright. Maximum loss is the premium, so the risk is defined.
- Level 3 covers spread strategies using multiple contracts with different strikes or expirations.
- Level 4 covers naked calls and puts. Because losses can run without limit, this level requires significant experience, high net worth, and substantial margin capacity.
New traders should expect to start at Level 1 or 2. Brokerages can also deny or downgrade approval at any point based on account activity or changes in your financial profile.
How Option Contracts Are Taxed
Option profits and losses are generally treated as capital gains and losses. Whether a gain is short-term or long-term depends on how long you held the option, not the underlying stock. More than one year is long-term; one year or less is short-term.8Internal Revenue Service. Topic No 409 – Capital Gains and Losses Because most standard options run only a few months, most option gains end up at the short-term rate.
If an option expires worthless, the premium becomes a capital loss, with the holding period running from your purchase date to the expiration date.9Internal Revenue Service. Publication 550 – Investment Income and Expenses
The 60/40 Rule for Index Options
Index options and certain other “nonequity” options get special treatment under Section 1256 of the Internal Revenue Code. Regardless of holding period, 60% of the gain is taxed at the long-term rate and 40% at the short-term rate. Standard options on individual stocks are classified as “equity options” and excluded from Section 1256 treatment unless you’re a registered options dealer.10Office of the Law Revision Counsel. 26 USC 1256 – Section 1256 Contracts Marked to Market
Wash Sales
The wash sale rule applies to options the same way it applies to stock. If you sell an option at a loss and buy a substantially identical option within 30 days before or after the sale, the IRS disallows the loss deduction. The disallowed amount is added to the cost basis of the replacement position, so the tax benefit is deferred rather than lost outright.11Internal Revenue Service. Case Study 1 – Wash Sales Active traders who close a losing position and immediately reopen a similar one get caught by this most often. Your broker will typically flag wash sales on Form 1099-B, but tracking them across multiple accounts is your responsibility.