Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!

Positions: Opening and Closing

Well, I sure hope everyone had a nice Thanksgiving holiday, but now it's time to get back to options!

As I'm sure you'll recall, Put options give you the right to sell stock at the strike price and Call options give you the right to buy stock at the strike price. When trading options, you can either buy them or sell them. Many people who are new to trading think that first you must buy an option before you can sell it. That's certainly logical, but in our trading world, a completed or closed position consists of a buy and a sell, but it doesn't have to be in that order. So yes, you can sell first, and then close the position by buying! This is similar to shorting stock, and then covering it later by buying it back. The difference, which isn't important to us at this time, has to do with the mechanics and behind the scenes handling of shorting stock. When you look at an options trading platform, there will normally be 4 choices:

If you currently don't have a position, you're first transaction will be either "Buy to Open" or "Sell to Open." Get it, you're opening a position. Some additional useful terminology; if you "Sell to Open" then you are said to be "Writing" the option, and it doesn't matter if it's a Put or a Call. It's also referred to as being "short" the option, or "naked." If you "Buy to Open" then you are "long" the option. You can remember this by thinking "since I bought the option, it beLONGs to me." Silly, but effective!

Now that we know how to open a position, the next question is how do we close the position? There are 3 ways:

Notice that if you bought the option, then you can exercise it. That is the right you have that we've been talking about, it's your choice. On the other hand, if you're assigned (some people say "exercised") then you have to fulfill your obligation. And what does that mean? Here's what happens - the option ceases to exist and you will now have a long or short stock position, as follows:

So as an example, let's say that in our account, we were long 10 XYZ Dec 50 Calls and XYZ is currently trading at $57. If we decide to exercise these Calls, we'll be able to buy this stock for $50 a share. Since each Call represents 100 shares, and we have 10 Calls, we'll need to pay $50 x 100 x 10 = $50,000. If we want to, we can now sell the 1,000 shares of stock in the open market for $57,000, sounds like a good deal, right? Well, maybe. Did we make or lose money on this transaction? It's a trick question, because we don't have enough information to know. It depends on what we originally paid for the Call options. If we paid $4 (total $4,000), then we made $3,000 ($7,000 - $4,000). On the other hand, if we paid $8 (total $8,000) for the Calls, then we ended up losing $1,000 ($7,000 - $8,000).

Since this might be a little confusing, let's look at another example. Suppose now that we sold 5 XYZ Dec 50 Puts @ $4, and then with XYZ trading at $45, we're assigned. How did we do? Well, we have to buy 500 shares of stock for $50, total $25,000, and then we can sell it out in the open market for only $22,500, which looks like a loss of $2,500. However, we sold the Puts for $2,000 ($4 x 100 x 5) so our net loss was $500 ($2,000 - $2,500).

An interesting point about the exercise/assignment process is that when you want to exercise an option, you call your broker (very few platforms let you do it online, you have to call) and it happens that night. Then through a random process, assignments are distributed to those accounts that have a short position in the option. The problem is that you don't find out about the assignment until the next day, either by seeing a change in your stock and options positions in your account, or by getting a call from your broker. It can be quite a surprise if you're not expecting it.

Since we're always going to want to know how much money we made or lost on an options transaction and it can be tricky at first, let's always try to do the calculation in the same way. Let's assume we have an option in our account that we hold to expiration. At that time we know it's worth either its intrinsic value or 0. After years of teaching, I have found that the following 4 step process works best. Of course, after you do enough of them, it becomes second nature, but for now, let's do it like this:

1. Calculate the value of one option without regard to whether you bought or sold it.

2. Recall the price you originally paid or sold it for.

3a. If you originally bought, then to close the position you have to sell, so your profit (on 1 option) is #1 - #2, i.e., what you sold it for minus what you paid for it. Note, a negative result indicates a loss.

3b. If you originally sold, then to close the position you have to buy, so your profit (on 1 option) is #2 - #1, i.e., again, what you sold it for minus what you paid for it (same as 3a). Note, a negative result indicates a loss.

4. Multiply the result in 3a or 3b by 100 times the number of option contracts. That's our total profit or loss.

Let's work a couple of examples:

We bought 5 of the XYZ Dec 35 Puts @ $6, and at expiration XYZ is $37.
Then, 1) $0, 2) $6, 3)a $6 loss, 4) $3,000 loss

If at expiration XYZ is $29.
Then, 1) $6, 2) $6, 3)a $0, 4) Breakeven

We sold 8 of the XYZ Dec 45 Calls @ $3.75 and at expiration XYZ is $47.50.
Then, 1) $2.50, 2) $3.75 3)b $1.25 profit, 4) $1,000 gain

Finally, if at expiration XYZ is $51.50.
Then, 1) $6.50, 2) $3.75, 3)b $2.75 loss, 4) $2,200 loss

Well, good work. I know that for some this was kind of easy and maybe even obvious, and for those with less experience, this type of calculation might be more challenging. The key is that we have a consistent method to determine if a position was profitable or not. Later on when we get to spreads, this method will really come in handy.

As always, if you have any questions about my articles or have suggestions for future topics, feel free to email me at: SFreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.

11. Know Thy Options!

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

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