By Josip Causic, Online Trading Academy Options Instructor
Education is usually the first thing to get cut in times of financial difficulties by the local and state governments. Many times the label "Back to the Basics" is being used as a justification for the sole academic focus on Math, Reading and Writing at the expense of Fine Arts. However, in our case of strictly options education, there are no cuts or short cuts.
The types of questions I have been receiving over the past month or so have been an indication that many of the members of the Online Trading Academy community are not at the level where advance option strategies (such as Condor Spreads, Iron Condors, and multiple simultaneous option trades) could be easily comprehended. Hence, for the time being, I will go "Back to the Basics" to ensure that some of the fundamental concepts of options are clear to the majority of the Online Trading Academy community. (It is my belief that option trading could be mastered only if one has a very solid foundation of what options can do and how they can be used.)
An option trader must have a complete awareness of all possible outcomes when entering an option position which could be beneficial as well as hurtful. By our human nature we tend to be optimistic, yet as option traders, we need to find the middle ground between our optimism and scepticism. Hence, when entering an open position with the order stating that we are ready to either BTO (buy to open) or STO (sell to open), we must be grounded in reality. The consequences of our mouse clicking actions could go against us as well as in our favor. In many case, the former is the most likely occurrence.
We can quantify the outcomes of our BTO actions in three possible scenarios. Figure 1 presents the outcome visually.
| 3 outcomes for a long or (BTO) option position |
Action |
Time |
Outcome |
STC |
Prior to |
Depends |
None |
@ expiry OTM |
Max Loss |
None |
@ expiry ITM by a penny |
Assigned & exercised |
Figure 1
The first one would be closing our open position with an opposite closing transaction stating STC (sell to close). For the sake of this discussion, whether we closed it for a profit, loss, or just at BEP (break-even point) is irrelevant. Therefore, on Figure 1 for "Outcome" I have placed the word "Depends" because more specific data is needed to make any generalization.
The second possibility would be to take no action whatsoever and wait for one of the two possible outcomes at the expiry. At the expiration our long position is either OTM (out of the money) or ITM (in the money). In case of our long call or put being OTM at the expiry, we have achieved our maximum loss of the premium paid at the entry, plus our initial purchase commission.
In the case of ending up ITM, even by a single penny, according to the new rules and regulations of the O.C.C. (Option Clearing Corporation) our option would get exercised. As much as we, as option traders, could disagree with this recent enforcement of exercising of any ITM options even by a penny, there is no possibility of turning back the clock to the time when the automatic closure of our positions was done only on the 25 cents ITM options by our brokerages. Those days are gone. The logic of closing a long position that was ITM by the 25 cents by a broker was commission-based. In those days, on the Friday morning of expiry, the brokers used to send out an e-mail to us stating that if the options which are ITM by 25 aren't closed by 11:00 A.M. Eastern Standard Time, it will be up to their discretion to close it at anytime between 11 AM and the close at 4PM EST. By the way, a-25-cents on a single contact equals 25 dollars out of which the brokers would pay themselves first, many times charging double commission. For instance, 9.99 for the ticket, plus 0.75 per contract as well as addition 10.00 fee for an "Assisted Trade." Again, the specifics of the commissions vary by the broker, yet I want the readers of our Online Trading Academy community to be aware of all the consequences involved with option trading, especially when selecting inactivity as a part of our option trading strategy.
Nonetheless, it is better if we close our own ITM position than to wait for our broker to take action on it. Inactivity always has a cost. Be aware where your open position is trading during the week of expiry and act according to your original plan which was supposed to be created at the entry.
Moving on to the possible outcomes of the short option position or STO (sold to open) position. Once again Figure 2 highlights three possible scenarios.
| 3 outcomes for a short or (STO) option position |
Action |
Time |
Outcome |
BTC |
Prior to |
Depends |
None |
@ expiry OTM |
Max Profit |
None |
@ expiry ITM |
Big Loss* |
(Asterisk stands for the loss defined by the current stock price action minus the premium received for the sold option.)
Figure 2
In case of selling something, the sale precedes the purchase. Chronologically, we first STO and then we BTC; or we sell high with the aim to buy back at the lower price. Many new traders who get exposed to options could not get over this concept that indeed it is possible to sell something before you even own it. If there is enough money in our account to perform such transactions of covering the expense of selling something, then the broker would allow us to proceed with our short transaction. However, in case we do not have enough funds in our account to meet the broker requirements, the short transactions will be rejected.
Hence, the outcome of the first scenario is to close our open position by selecting BTC (buy to close). Again, I am leaving out of this discussion the whole concept of for profit or a loss; I am focusing only on us taking this action of BTC prior to the expiry.
The second outcome could involve leaving the position open or unclosed until the expiry and observing the inactivity outcomes. Again, there could be two outcomes. One desired one and the other undesired one. When we sell something the only way to achieve the maximum profit is by letting our sold option expire completely worthless, meaning the option premium goes down to zero and our option expires worthless. (Hopefully, when we sold the option there was a juicy premium in it, making the selling transaction worthwhile. I advocate the selling of OTM options that have some extrinsic or time value left in them.)
The third and least desirable outcome for our sold option is the exact opposite of being OTM. In the case of our sold option ending up ITM prior to the expiry, we must either buy back our obligation no matter what the current price is or suffer the consequence of our inaction. Option trading always requires monitoring our open positions and acting according to our initial trading plan. At Online Trading Academy, we always teach: Plan the trade and trade the Plan. A failure to plan a trade prior to entry is indeed planning to fail.
In conclusion, in this article I have pointed out that without a deep understanding of option fundamentals, an option trader could not break to the higher level of advanced option trading. I have laid out some of the basics which are often overlooked by many. It is in the clear understanding of the fundamental intricacies of options that the secret of solid option foundation lays. There is no shortcut in learning the options; an in-depth comprehension of basic concepts must precede the more advanced ones. Good trading, and make sure to have a clear plan prior to getting into any option position.
- Josip Causic
jcausic@tradingacademy.com |
