In the beginning, options trading will most likely be a little confusing. These sections are valuable and should be reviewed until the concepts are clear. As you read ahead, refer back to these sections for clarity and it will all come together.
Basic Mechanics of Going Long and Short
It is essential to have a good understanding of the terms “long” and “short” before we move further into option strategies.
Describes a position in which you have purchased and own a security (i.e. a stock or an option). For example, if you have purchased the right to buy 100 shares of a security, you are long one call option contract. If you have purchased the right to sell 100 shares of a security, you are long one put option contract. If you have purchased 100 shares of a security outright you are simply long 100 shares.
Describes a position in which you have sold a security you don’t own. In return, you now have the obligations inherent in the terms of the short stock or option contract. For example, if you have sold the right to buy 100 shares of a stock to someone else, you are short one call option contract. If you have sold the right to sell 100 shares of a stock to someone else, you are short one put option contract. When you write an option contract, you are in a sense, creating it. The writer of an option collects and keeps the premium received from its initial sale. Below is a quick guide to the terms and how they relate to options.
Buy/Sell Buy Call
Long/Short Long Call
Sell Put Buy Put
Short Put Long Put
Buy Put Sell Call
Long Put Short Call
When you first buy (or write) an option contract with your broker, it is called an opening transaction. If you then sell (or buy) the same option to cancel a position, it is called a closing transaction. For example, an instruction to your broker to buy to open 10 call options in ABC (ABC) expiring in November with a strike price of 30 is called an “opening transaction.”
If, after one month, you decide you do not want to remain in the position, you would instruct your broker to sell to close 10 ABC November 30 call options as a “closing transaction.” Once the closing transaction has been transacted, the initial open option contract is cancelled, and you will have no further rights (or obligations) arising from the ABC call option contracts. It is very important to always tell your broker when placing an option order, whether it is an opening or closing transaction.
Exiting a Trade
Basically, there are three alternatives when exiting an open option transaction:
Offset the transaction;
Exercise the option; or
Let the option expire.
Experience is the best teacher when it comes to choosing the best alternative. Since each alternative has an immediate result, learning how to profitably close out a trade is essential to becoming a successful options trader.
Offsetting is a closing transaction that cancels an open position. It is accomplished by doing the opposite of the opening transaction. There are four ways to offset an option transaction:
The best time to offset an option is when there are gains on the position. Offsetting is also used to avoid incurring further losses. An option can be offset at any time. It does not matter whether it is one second after it has been entered or one minute before expiry. It is very important to know the expiry dates of your open option positions so that you avoid leaving a nice profit on the table. Offsetting an option position is generally the most popular technique of closing an option trade for option buyers.
Exercising a long option position will close your open position by taking ownership (call) or delivering (put) the underlying shares at the option’s strike price.
By exercising a long call option, you close your open call option position by taking ownership of the underlying shares. If you want to exercise your long call option:
Simply notify your broker, who will then notify the Clearing House.
The Clearing House. will randomly select a writer (seller) in that series of call options and on the following day notify that writer that their written (sold) position has been exercised and they must deliver to you the corresponding number of shares in the underlying stock.
If you choose to exercise your call option (you would only do this if the stock price is above the option’s strike price), your trading account will then be debited the purchase price of a 1000 shares (per contract) in the underlying stock at the call strike price. You will now own the underlying shares at the call strike price.
Exercising a long put option will close your open put position by selling your ownership of the underlying shares. If you want to exercise your long put option (rather than close it):
Simply notify your broker, who will then notify the Clearing House.
The Clearing House. will randomly select a writer (seller) in that series of put options and on the following day notify that writer that their written (sold) position has been exercised and they must purchase from you the corresponding number of shares in the underlying security.
If you choose to exercise your put option (you would only do this if the stock price is below the option’s strike price), your trading account will then be credited the value of 100 shares (per contract) in the underlying stock at the put option strike price. Your shares will now be carried away at the put strike price.
You can exercise an American option at any time on or before expiry; but typically, you would not do it (that’s if you exercise it at all) until just prior to expiry. An option writer cannot exercise an option. By writing an option, you are taking the risk of having a buyer exercise the option against you if the market price movement makes it an ITM option.
Letting it Expire
Letting an option expire is used when the option is out-of-the-money (OTM) or worthless close to the expiry date.
Also, for short (written) options, letting them expire is the best way to realise a profit. If you let a short option expire, you get to keep the premium received when you opened the position. To make the most of any option, traders with open positions need to keep track of the price of the underlying security each day. A momentary fluctuation in price can mean the difference between opportunity and crisis. Luckily, computers make this process easier and more efficient than ever before.
Assignment is one of the more confusing processes of an option. Although it occurs infrequently, it is an important part of basic option mechanics. All option traders need to have a solid understanding of assignment in order to maximise their chances for success. Assignment is the term used to describe the option writer’s (seller’s) obligation to sell or buy the underlying stock at the strike price at which they sold the option contract at. The buyer of an option has the right (but not the obligation) to exercise the option (i.e. buy the underlying stock at the strike price for a long call, or sell the underlying stock at the strike price for a long put). Typically, most option writers will not want to be assigned at expiry. Hence, if their short position looks like having any chance of expiring ITM, and thus not expiring worthless, they will close out the short position to avoid the risk of assignment.
Option Trading Summary
Let’s get right to the heart of the issue. In essence, an option is the right, but not the obligation, to do something. Options provide choices for how we wish to proceed. Options serve as a contract between two parties—a buyer and a seller—conveying the right, but not the obligation, to buy (call) or sell (put) a specified underlying security at a fixed price within a predetermined time period for a specific premium.
An option is the world’s most versatile trading instrument. It enables traders to capitalise on the bullish or bearish moves of an underlying market—usually with much less initial investment capital. Buying an option offers limited risk and unlimited profit potential. In contrast, selling an option (also known as writing an option) comes with an obligation to complete the trade if the party who buys it chooses to exercise the option. Selling an option therefore presents the writer with limited profit potential and significant risk, unless the position is hedged in some manner.
Options are the perfect trading instrument for leveraging your capital and hedging your portfolio against risk. They act to protect your investments just as buying insurance would for your car or home. To be successful in today’s markets, you need to evaluate your current positions to see what you can do to be successful as you move forward. Finally, understanding the ins and outs of assignment and how it works in real-world trading is vital to becoming a successful options trader.
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