days on Friday.
✔ Keep up with your last exercise day: The last trading day and the last day to exercise usually fall on the same day. In most cases, you have one hour after the market closes to submit your instructions to your broker. But some brokers may have different rules, thus it’s important to check and know this well before you make any trading or exercise plans.
Detailing your rights
When you buy a call option, you are buying the right, but not the obligation, to buy a specified amount of stock at a certain price (strike price) at any time (just about) before the expiration date. This right lets you either exercise your right or trade out of the position.
When you buy a put option, you are buying the right, but not the obligation, to sell a specific amount of stock at a specific price (strike price) at any point in time (just about) up to the option’s expiration date. During this defined period of time, you can exercise your rights as an option holder or decide to trade out of the position.
It is quite possible that you may never actually exercise an option, as the option position may be part of an overall trading strategy you have devised. That’s the beauty of options, you have rights which give you the choice to act in the way that makes the most sense based on your strategy and market conditions. However, if you decide to exercise an option, here are some advantages:
✔ Exercising a call option: When you exercise a call option, you may benefit from the shareholder rights of the underlying stock. This could mean that you receive cash or a dividend or that you participate in the benefits of other corporate actions such as mergers, acquisitions, and spinoffs.
✔ Exercising a put option: Exercising a put option lets you exit a stock position. This could come in very handy when a company releases bad news after the close of regular trading in the stock market.
Exercising either a call or a put option: This practice may be of help in minimizing commission costs. By selling the option and then buying or selling the stock in the open market, you generate an added commission.
Even though the last bullet sounds confusing, there are times when selling the rights inherent in an option, to buy a stock in the open market, makes sense from a profit and commission savings standpoint. Chapter 9 covers this strategy in detail.
There is an important difference between what it takes to issue new shares of stock and how options contracts come to exist. The number of shares available to trade in a particular stock is called the float. If there is a need for more stock to be issued, shareholders vote on whether it is sensible or not to do so, and the company goes through a process of registration before the new shares are offered to the public.
It’s different with options, where the potential number of contracts possible is limitless because options contracts are offered based on demand. The actual number of existing contracts for any option is known as the open interest.
Opening and closing positions
When you enter your order to buy an option, there may or may not be a contract available. But you won’t know that since your demand will create a contract if one isn’t already available. The important factor is how you enter and exit positions. The type of order you enter will lead to the execution of the trade. Attention to detail is very important, so you need to pay close attention to how you enter your order, and that means specifying whether you are opening a new position or closing an existing one. To buy a call option, you would enter the following order:
Buy to Open, 1 XYZ June 21 35.00 strike call option
To exit the position, you would enter the following order:
Sell to Close, 1 XYZ June 21, 35.00 strike call option
The same type of order format applies to opening a position in an option that you don’t own. The important factor is the correct use of language and the specificity of the option you are selling. Use the following to sell an option you don’t own:
Sell to Open, 1 XYZ June 27 42.00 strike call option
Buy to Close, 1 XYZ June 27 42.00 strike call option
When you enter your orders correctly, it allows the exchange and the clearing company to keep accurate track of the number of open contracts, which is also known as the open interest, and to keep tabs on the number of contracts traded on any given day. The open interest number displayed on options contract quotes has a one-day delay, meaning that today’s number is accurate up to the prior day’s action.
Selling an option you don’t own
When you sell an option as an opening transaction, you are obligated to sell a stock at the strike price at any time until the option expires. During that period, if a call option holder decides to exercise their rights, you may have to meet your obligation. When this happens, it’s called being assigned the option, and your broker will contact you to inform you about it. When you are assigned on a call option contract, you must weigh two possibilities:
✔ If you own shares of the underlying stock, you must sell the shares and close the stock position.
✔ If you don’t own the shares of the underlying, and you don’t sell the shares, you have created a short position in your account.
The easy part of selling an option that you don’t own is putting in your order. The more important part is understanding the risk of the trade. If you own shares when you sell a call option, it is known as a covered transaction, because the shares cover the short call position. If you don’t own the shares when you sell the call, it’s called a naked call. What makes this strategy most dangerous is that it has the same risk as a stock short position. In other words, your risk of loss is unlimited, given the potential of a stock to continue to rise indefinitely.
When you sell a put option as an opening transaction, you are obligated to buy a specified amount of stock at the predetermined strike price at any point until the option expires. You own this obligation from the time you open the transaction until the expiration weekend and you are require to satisfy the obligation if a put option holder decides to exercise their right. Getting assigned on a short put usually happens when the underlying stock has declined. If assigned you will be buying stock at a higher price than the current market value. Your short put transaction can also be covered or naked.
When you sell a put short, you are under obligation to buy shares, so you cover the position with a short stock position in the underlying. Buying the shares closes the short stock position. If you sold a naked put and you are assigned, you will have a new long position in your account.
Selling puts is a tricky transaction, so it takes a little time to figure it out. Here is why:
✔ When you take on the obligation associated with this transaction, you are no longer making active decisions with regard to the transactions involving the underlying stock.
✔ The risks associated with the short option transactions are very different, depending on whether you have a covered or naked transaction.
I cover the risk reward ratio of transactions more fully in Chapter 4.
You not only want to get off on the right foot when you begin trading options, but you also want to keep both feet firmly grounded throughout the process. The following tips should help:
✔ Get approval. When you want to start trading options, you need to get approval from your broker.. the Securities & Exchange Commission (SEC) requires it. They need to make sure that trading these securities is appropriate for your financial situation and goals. It’s part