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 of the process and means you typically get approved for basic option strategies if you haven’t traded them in the past.
✔ Be disciplined. When you enter a trade for a specific reason, such as an earnings announcement, pending economic report or a particular value for an indicator you use, you must exit the trade when conditions change or your original reason for purchasing the security no longer exists. Don’t let a stock or option position you intended to hold for three weeks become part of your long-term portfolio. Being disciplined and following your rules is a must for all traders.
✔ Keep track of the expiration date. Many option chains include the actual expiration date for each month along with the option quote data. The expiration date may also be included with your account position information. Knowing when the option expires is critical to managing the position.
✔ Practice. Always remember that you can paper trade a security that is new to you. Although the emotions you experience trading this way don’t exactly mimic having real money on the line, it helps you get familiar with new types of securities.
Chapter 3
Trading Places: Where the Action Happens
In This Chapter
Your trading career probably started with the stock market. Because there are plenty of similarities between stocks and options, comparing the two takes advantage of your base knowledge to expand firmly into a new trading environment, so we do that where possible in this book.
Covering options from a trader’s standpoint, this chapter provides information about the option exchanges you encounter, the different market participants impacting your transactions, and the market conditions that affect your trades. All these things have some influence on your trading success. The biggest key to success though, is really getting a handle on the factors that come into play when valuing options. With that in mind, we introduce formal option pricing components, known as the Greeks.
There are six option
