option basics

Early Assignment

I’ve heard it said that most options expire worthless. This claim generally comes from non-option traders trying to convince would-be traders not to start. It’s just not true. The vast majority of option positions are simply closed before expiration. Even though a large number expire, plenty are exercised/assigned.

The term exercise refers to an option buyer exercising their right granted by the option. Call buyers have the right to buy stock at the strike price anytime before the option expires. Put buyers have the right to sell stock at the strike price anytime before the option expires. Their act of doing so is known as exercising.

The term assignment refers to an initial option seller, also know as the option writer, being exercised by the buyer of their option. Call writers have the obligation to sell stock at the strike price anytime before the option expires. Put writers have the obligation to buy stock at the strike price anytime before the option expires. When they are forced to fulfill their obligation, it is known as being assigned.

The last day for option buyers to exercise their rights and option writers to be assigned their obligations is on expiration Friday. Technically, option expiration happens the Saturday following the third Friday. Since the stock market is closed on Saturdays and since most brokerages also make their retail clients announce their intentions by the third Friday, most people consider this day as option expiration day.

On stock options, the buyer of an option can exercise their right at any point until expiration. That is any time they want, but it won’t reflect when the market is still open. The shares will trade hands after normal hours. Disappearing from the assigned Call writer’s account and/or appearing in the assigned Put writer’s account, before the open of the next business day. Their broker should inform them of assignment before the market opens.

Most exercise/assignment takes place on the last day, expiration day. But since stock option buyers can exercise their rights at anytime until expiration, it is possible to take place “ahead of schedule.” When an option buyer chooses to do so, it is known as early exercise. Logically, when the writer receives notification, it’s known as early assignment.

Selling Naked Puts has its own risks and rewards. Some aspects, which are thought to be risks, may actually be rewarding. Early Assignment falls into this category.

Calls are almost never exercised early. If their buyer does so, he has to come up with the money to pay for the stock. On the other hand, Put buyers often exercise early. When they exercise their right to sell stock, they get paid. They collect the money for the sale. I’ve been assigned early on Puts numerous times. I’ve been called out early only once in the last few years. I know very few Covered Call writers that have ever been called out early. Money has value; it collects interest. Follow the money!

Time Merchant

Selling options is akin to selling time. Option writers collect premium by obligating themselves for certain periods of time. If the buyer of those options decides not to exercise the time will expire and with it the option. But if the option buyer chooses to exercise early, they aren’t using time they’ve previously paid for. Maybe it can be resold.

Option buyers can sell their options anytime the market is open. As long as there is time value remaining, they would be foolish to exercise. By doing so they lose the time value. If and when they do, they have to lose it to someone. That someone could be you. Be aware, this opportunity generally never avails itself, but when it does, be prepared to profit.

Usually options are only assigned early when they are so Deep In the Money (DITM) they have no time value. Also early assignment might happen one or two weeks before expiration, but not often any earlier than the last week before.

How To Profit When Assigned Early Using a Totally Hypothetical Example:

Stock XYZ closed @ $ 33. The $ 40 Puts closed @ $ 7.50 bid, $ 8.00 ask. Their intrinsic value equals the amount In the Money (ITM) $ 7. Whatever remains forms the time value, in this case less than a dollar. But instead of selling the Puts on the open market, their buyer chooses to exercise early. If we wrote these Puts and were the early assignment “victim,” we could receive a windfall profit.

There’s two ways to resell the time. One way is to sell a Covered Call against the stock just bought. If the prices remain the same the following day when we found out we were assigned early, the $ 40 Call should be priced around $0.50 bid, $0.75 ask. Although we may get a better price than bid, let’s assume we sell the Call @ $0.50. If the stock rises above $ 40 and we get called out; it’s the same net effect as never being Put in the first place. We would NOT own the stock, but we would have picked up an extra $0.50.

Selling options can be very profitable. To the trained trader the numerous risks are more than offset by the potential rewards, including those that almost never appear. Training comes from experience; not necessarily one’s own. Being aware of circumstances that hardly ever appear allows profits if/when they do appear.

Since options decay as time passes, selling them has an advantage.  Every day that passes, including weekends and holidays, lowers their value.  Since the goal in selling options is to buy them back lower, having the certainty of time’s passing is a great ally.

Selling uncovered or “Naked” Calls has theoretical unlimited risk.  Call option sellers, or writers as they are also known, obligate themselves to deliver a stock at a set price no matter how high the market goes.  The seller of a Covered Call doesn’t have market risk of a runaway stock, because they can deliver out of their own inventory.

Selling Naked Puts obligates the sellers to buy the stock at the strike price if the buyer of the Put chooses to exercise their right.  In a sense, writing a Put is like writing an insurance policy.  If the stock crashes, it crashes on the insurance company, the Put seller.

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Selling options can be played two ways.  First, you can sell them with the intent of buying them back later for less.   The basic buy low/sell high, albeit in reverse order.  Or you can sell them and hope they expire worthless for the person who bought them.  Sell high without ever having to buy.  Question:  Is it Infinite Return Investing when you profit from things without a cost basis?

Naked Puts have the same risk characteristics as Covered Calls.  Basically if the stock price closes below the strike price, the writer of either option will own the stock.  On the Covered Call, they will own the stock because they won’t be called out.  The writer of the Naked Put would own the stock because it would be Put to him.

On the same token; if the stock price is above the strike price, both option writers would NOT own the stock.  The Covered Call writer would be called out, while the Naked Put seller would have stock assigned to them.

The Put premiums should almost equal the Call premiums.  Their only true difference should work out to the Interest Rate and/or Dividend calculations.

Margin

A big advantage to selling Put options is the lower margin requirements.  When you buy a stock, whether you write Covered Calls or not, you have to pay for it.  You may be able to buy it on margin.  Typically margin works this way; your broker will loan you 50% of the value of a stock.  They’ll use stock as the collateral for the loan.  Interest rates vary from broker to broker.

If the stock increases in value, your broker will let you borrow additional sums.  But if the stock price drops, the broker may ask for more money.  Generally, they want to have at least 35% equity.  Any less than that will cause a house call or margin call.

Margin calls are not phone calls you want to receive.  If you can’t come up with the extra money to bring your account to the minimum requirements, your broker has the right to sell your position off at a loss to you.  There’s nothing you can do but turn an unrealized loss into a realized one.  You ‘re obligated to give them security or pay them their money.

Margin also measures security.  When allowing Naked Put selling, brokers will require a certain amount of good faith money.  This is also known as margin.  Typically the margin requirements for selling Naked Puts will be 50% lower than buying stock.  It works out to around 25% of the value compared to 50%.  Since it only takes a small fraction of the price to obligate oneself to buy it, only more experienced traders should consider selling uncovered options.

Margins can and do change, often dramatically.  Brokers typically want a minimum 25% of the strike price before allowing Put writing.  Some will allow you to subtract the amount Out of The Money (OTM) on the option.  Example: a $50 Put on a $55 stock is Out of The Money by $5.  The margin required to write this Put would be $7.50.  One fourth of the $50 strike equals $12.50, minus the $5 OTM totals $7.50.  If the stock were to drop, the margin required would increase.  A $50 Put on a $53 stock equals $9.50, $12.50 less the $3 OTM.  If the stock dropped another $5 down to $48, the margin would increase to $14.50.

A One Dollar drop in the stock raises the margin requirement by the same dollar.  A Five Dollar move on a $50 dollar stock equals 10%, but the margin could move by 50% or more.

Either start with a lot of money or be prepared for margin calls.  For that matter, only consider Naked Puts with your excess money.  Cash lying around in accounts doesn’t provide income like selling Puts can.  But solely selling Puts can tie up money that could be used better buying options.

 

Knowledge of probability and statistics will allow traders to greatly increase profit possibilities while limiting risk.  But knowledge of math is not required to enhance one’s trading.

Recognizing chart formations acts like recognizing opportunities.  Both opportunities to profit, but also opportunity to avoid bloodbaths.  Stock and option traders can either participate in major moves to their benefit or detriment.  Numerous common technical patterns exist that can be employed to identify favorable entry and/or exit points.

Trend lines, support and resistance are required for any technical assessment.  But these may be considered as just building blocks for more complex patterns.  One of the simplest of these complex chart formations is known as a “Head-and-Shoulders.”

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Made famous by Charles Dow, this major reversal pattern was and has appeared in every major market top or bottom in the last fifty years.  This formation is a precursor to both market rallies and major corrections.  It is accurately described as a “Head-and-Shoulders” top or bottom.

“Head-and-Shoulders Tops” look just like their name implies a “Head” (highest high) flanked by “Shoulders” (lower highs).  Separating the head from either shoulder is the neckline.  Made up of lows of similar time and price formation the “necks” do not have to be identical, but the closer to being a mirror version of each other, the higher the probability for a trend change in the other direction.

Double tops are widely considered as points of great resistance.  Think of a “Head-and-Shoulders Top” as a triple top with the center top having a higher high.  Add to that the fact that the neckline adds a point of support that if broken often foretells a stocks rapid decent.

As with any pattern, there can be a number of small variations.  For example, there may be two or more left shoulders near the same price range, or two or more right shoulders.  In any case, the most important component of the formation is the neckline.  When it is broken, the pattern is complete and a significant change in character often follows.  The following drop is often the most precipitous of the entire formation and occasionally will eclipse the height of the pattern (the top of the Head to the Neckline).  As the new character evolves, successive rallies commonly fail at lower highs until the overall decline is far greater than the magnitude of the initial formation.

For the next paragraph either stand on your head or hold your monitor upside-down.

Once a trader learns “Head-and-Shoulders Tops,” they should have an easier time understanding “Head-and-Shoulders Bottoms.”  Basically, bottoms are tops upside-down.  That is, the shoulders are higher than the head and the necks are short-term highs not lows.  “Head-and-Shoulders Bottoms” signal trend reversals with high probabilities of upward price appreciation, bullish reversals instead of bearish reversals.

It’s obvious you should never overlook the potential of a clearly formed and definitely broken trend.  The historical traits of well know patterns demonstrate the ease in profiting from their analysis.  But the difficulty may come from seeing the second shoulder before the opportunity has been diminished.  Experience will help traders see them as they’re formed.

The Beauty of understanding chart patterns surrounds the fact traders can study them without risking their accounts by looking at existing charts.  Study as many as possible.  I hope that my examples have helped.  I hope this article has also helped.

About fifteen years ago, my first stock broker told me a story that happened to him almost twenty five years earlier.  I can’t remember all the details, so it can’t be verified.  He swore it was true, and if you can’t trust your stock broker who can you trust?

To make this point, I’d like to share the story the best I can remember.  It takes place when my broker started in business, in the early 1960’s.  He had some clients wanting to buy stock in a company he had never traded before, but the name was familiar.  In doing research about the company, he discovered a new company had bought the “corporate shell” of an older, out of business company.  (It is a long and difficult process to turn a company into a publicly traded company.  Many times it is easier to merge into the “shell” of an abandoned company, and fill it with your own “slug.”)

This “new” stock hadn’t traded for years, maybe even decades, but now had volume and an increasing price.  Why was this company familiar?

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My broker told of being at his childhood home and realizing the reason for the stock’s familiarity.  He remembered, his parents had lost a fair amount of money in the “old” company years earlier.  All that was left of the monumental loss was the reminder his father had framed and hung on the wall… the stock certificate.

The story goes, he took the certificate off the wall, sold it to his client.  Giving his widowed mother the money and earning a large commission from his satisfied client.  If I remember the story correctly, the new company went the way of the old, it once more became a shell.

The moral of the story; If you own a stock long enough it may come back from the dead.

With an option, there is no after life, no reincarnation!  One funeral is all it gets.  If your option dies, you don’t get a certificate to hang on your wall.  All you have left is the trade confirmation from your broker and the memory of the money in your account.

Options are a fixed time investment.  After expiration, they cease to exist.  When buying options, you need to be right, and right on time.  Stock prices go up, they go down and they stay the same, but time always passes.

The nice thing about time, it’s consistent.  Time’s passage is an integral part of an option’s price.

Time Value and Time Decay:

Option prices can have two elements, Intrinsic value and Time value.  Intrinsic value is equity, a “down payment on the stock.”  Time value is potential.

If an option has time remaining, the stock has the capability to move.  Consider time value as possible movement value.  At expiration, there is no time, there is no potential.  The “Greek” term Theta measures the time value decay of an option.

The Laws of option pricing are constant.  The Laws regarding time value include; “The At the Money Option ALWAYS has the highest time value.”  “Time value drops the further In or Out of the Money the option moves.”  “Time value decays at its square root.”

My goal is to help people become better traders.  It is less a goal to teach which stocks to trade, and more a goal to teach identifying situations, and matching strategies to those situations.  If you know ahead a stock’s price is rocketing to the moon, it’s easy, just bet the farm.  However, if you’re not sure, you don’t know if a stock will soar, but you have sound fundamental information and technical analysis to help reasonably know the direction of price, you can learn to develop successful strategies.

I would like to think, I can give information worthwhile to read, worthwhile to learn, and more important, worthwhile to trade.

Most investors do not understand the difference between price and value.  Value is what a stock should be worth.  Price is the last trade of record.  The key to successful investing is finding undervalued and overvalued stocks whose price becomes more in line with their value.  This is also called reversion to the mean.

The daily opinion poll, known as the market, determines price.  Like the political climate in America today, the financial climate is often a confusing and changing environment.  Bill Clinton and Amazon.Com have a lot in common.  Contrary to long time expert opinions, both are scoring amazingly high in the public opinion polls.  Trying to call their early demise might be the biggest mistake of the end of the 20th century.

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My major problem is that I am a one man army.  Attacked on all flanks and seriously out gunned.  I had to develop a hand to hand combat method of investing… Trench Warfare.  I knew my weaknesses (market predictions) and my strengths (logic, mathematics, analysis, and experience).  I would pick my battles and my battlefields…Options.

I hate stocks.  Their valuations are one dimensional…PRICE.  Stocks don’t know time.  This is evidenced by one of the oldest forms of Technical Analysis: Point and Figure Charting.  Options on the other hand are multi-dimensional.

Option pricing is based on the values derived from the Nobel Prize winning Black-Scholes formula.  Options are derivatives.  That is they have no value in and of themselves, their values are derived from something else.

Sounds scary, doesn’t it?  Aren’t derivatives responsible for breaking a British Bank?  Actually it was a young rogue trader in Singapore misusing derivatives that broke the long time institution.  If he knew some of things I plan on teaching, history could have been different.

I intend to take a complicated mathematical equation and give you the basics to successfully trade with this information.

You will learn how options are valued.  The components are simple; Time, Price, Potential, Dividends, and Interest Rates.

Time:  The one true constant.  Stocks go up, stocks go down, stocks stay the same, TIME passes.  The value of time does not decay linearly.  For true math heads only… Time Value decays at its square root.

Price:  Not only the price of the stock, but the difference of the Strike price versus the Stock price.

Potential:  Known as Volatility, measured in Standard Deviations.

Dividends:  Applicable only to stocks that pay dividends.

Interest Rates:  Short term risk free rate of borrowing.

These Mathematical counterparts have Greek terms.  This adds to the difficulty experienced by seasoned Stock Brokers as well as neophyte investors.

Time Decay-Theta, Price movement-Delta and Gamma, Potential-Vega, Interest Rates-Rho.

Strategies include almost every kind of spread imaginable, and some only a veteran such as myself could dream up.  They will include:

Bull Spreads, Bear Spreads, Put Spreads, Call Spreads, Credit Spreads, Debit Spreads, Calendar Spreads, Ratio Spreads, Back Spreads, Butterfly Spreads, Condor Spreads, Anticipation Spreads, Subsidy Spreads, Straddles, Strangles Combinations, Time Diagonals, Synthetic positions and Position Trading.

If risk can be minimized or hedged away, there is a spread that can do it.

Sounds Great?  Well it’s meaningless if you can’t trade it.

The public opinion poll on Advanced Micro Devices (AMD) recently shown a less that happy result.  The price gapped down.  Not unlike many other stocks have done.

If you look at a long term chart of AMD you will see exactly why you don’t want to be a “long term buy and holder”.  This is a high tech company and the price hasn’t moved much?  Actually it has moved nicely, up and down!  Is now the proverbial Low from “Buy Low-Sell High”?  I don’t know.  But I can trade on the possibility.

AMD is almost a commodity.  They manufacture CPU’s to compete with Intel (INTC).  With consumers wanting less and less expensive computers, one would think things would be well for AMD.  However, Intel wants not only a bigger market, but bigger market share.  They have come out with cheaper chips to compete with AMD.  Chips that allow box manufactures the low entry price with the familiar Intel Inside logo.

We’ll enter a Position Trade, buying a long term call and selling short term calls against it.  We’ll look at a number of hedged positions where we buy and sell risk, buy and sell time decay and buy and sell potential.  It will cost us a certain amount of money to enter this trade and then a certain amount of money to maintain this trade.  The key to Position Trading is to have less money in the trade as time goes on and more profit potential.  It is money management.