I have written several articles about option trading in the past. In
June, for example, I wrote an article about trading call options.
Recently, I have had inquiries about some option positions so I would
like to elaborate a bit in order to help subscribers better understand
the consequences of being in certain option positions. To review,
options are contracts. The buyer of an option contract, whether it be a
put or a call, obtains a right. The seller of an option contract
undertakes an obligation and for that obligation receives a premium.
Almost all equities (stock) have options that are known as American
style. An American style option may be exercised at any time up to
expiration.
Those who have Option Trader subscriptions knows that I frequently like
to enter spread plays. A spread is simply a trade that has two or more
legs. As an example, I may find a stock that appears to be bearish. In
other words, it looks like it is going to go down. In such a situation,
if the stock has options, I might enter a bearish call spread. That
means I am going to sell calls with a lower strike price (but above a
resistance) and buy calls with a higher strike price as my protective
leg. Since one of the legs involves selling calls, I am undertaking the
obligation on that leg to sell the stock at the strike price any time
before expiration if I am assigned (called). When I enter the spread, I
probably do not own the stock, so I am buying the other leg (the
protective leg) to limit my losses in the event the stock goes up in
price. For example, let us assume that XYZ is trading at $34.30 and
there is a resistance at $34.75. In that circumstance, I might consider
selling the $35 call and buying the $37.50 call to create a bearish call
spread. The premium for the $35 call will be higher than the premium
for the $37.50 call so I will take in a credit upon entry into the
position. Let's assume that credit is $1.00. If the stock took off
to the high side, I could be assigned on my $35 calls which means that I
would have to sell the stock for $35 a share. Since I do not actually
own the stock, a couple of things could happen if I were assigned on the
$35 calls. First, I must sell the stock at $35 so if I just sell the
stock, I will have sold it short. That means I will have borrowed the
stock from my broker and sold it at $35 a share. That money from that
sale will come into my account in three business days. Since I borrowed
the stock from my broker, I must replace it at some time. In order to
replace the stock, I would "buy to cover" the position. Suppose the
stock price rose to $37 a share when I decided to buy to cover the
position. Now I would be buying the stock at $37 and had already sold
it at $35 a share so I would lose $2.00 a share. On the other hand,
suppose the stock fell and was trading at $33. In that case, I would
buy to cover at $33 a share that which I had already sold at $35 a share
so I would make $2.00 a share. It is important to note that any time
one sells an option, there is the risk that the option will be
assigned. In the case of selling a call, that means that I must sell
the stock at the strike price when assigned. (If I sell a put, I have
obligated myself to buy the stock at the strike price if it's
assigned). Assignment for American-style options can occur any time up to expiration.
In my earlier example of the bearish call spread, I mentioned that there
were a couple of alternatives in the event of assignment. One of the
reasons that I create a spread is to have a protective leg. In my
example, I sold the $35 call on XYZ and bought the $37.50 call. Since I
own the $37.50 call, I have the right to buy the stock at $37.50 anytime
before expiration no matter how high it is currently trading. Another
alternative, then, if I were assigned on a $35 call would be to, in turn,
assign my $37.50 call. That means that I would be selling the stock at
$35 and then would buy it at $37.50 which would mean I would lose $2.50
a share. However, remember, the market gave me a $1.00 credit when I
entered the spread so my actual loss would be $2.50 minus the $1.00
credit or a loss of $1.50.
In response to the questions I have received, it is important to keep in
mind that assignment can be made at any time up until expiration for
American-style options. If one is assigned on a call, one can either
exercise the other protective call leg that he owns or he can "buy to
cover" the stock he has sold short. If one is assigned on a put he has
sold, he is obligated to buy the stock at the strike price, but, of
course can immediately sell that stock, write covered calls against it,
or, if in a spread position, exercise the other leg and sell the stock.
At first, these concepts may be difficult to understand and seem
complex. That is one of the reasons why anyone contemplating the use of
such strategies should paper trade them before ever investing real
money. It is absolutely essential that the trader understand the
implications of each position before ever making a real money trade. If
the implications of the position or positions are not completely
understood, the trader should avoid the trade until he learns the risks
related to each. If you are new to trading or to a specific strategy
and are interested in these types of trades, I urge you to speak with a
broker knowledgeable in option trading. Many brokers are not
knowledgeable about option trading and should not be used in conjunction
with option trading. Many brokers, on the other hand, are very
conversant when option trading and constitute a marvelous resource for
which you are paying with your commissions. Don't be afraid to ask, but
first be sure that the person you are asking is familiar with the
strategy or strategies themselves.
For those who aren't offended, have a Merry Christmas. For those who
would be offended, have a wonderful weekend.
Good Trading!
Bill Kraft
Mr. Kraft's past articles are posted on our website for your review.
-- by the Dividend Investor Team
