Option Trading Terms & Definitions
After an option has been purchased there are two methods that can be used to realize a gain if it increases in value; it can either be sold in the open market or exercised. A trader who exercises an option agrees to take delivery of (in the case of call) or sell (with ownership of a put) the underlying asset at the option's strike price. Only option buyers have the choice to exercise an option whereas option writers have an obligation to purchase or provide the underlying issue, if assigned by the option owner, at any time prior to the expiration date. In return for this responsibility, they are paid a premium when the option is sold.
There are a number of unique terms that describe specific option trading activities but an important fact to remember is the initial trade in any position is always an "opening" transaction and the exit order is called the "closing" transaction. An opening trade occurs when a person establishes a new position as either the holder (or writer) of an option and that position can be closed only through the sale (or purchase) of an identical option. The word "offsetting" is sometimes used to describe the trade that closes a position and that action is initiated when it is necessary to remove an investor's previous obligation in the underlying issue. If an option has not been offset or exercised before expiration, it will become worthless. Fortunately, the potential loss to the buyer of an option can be no greater than the initial premium paid for the position. If you are an option writer, you benefit when it expires worthless because you retain the credit received from the initial sale of the option with no future obligation.
It is important to understand that most derivatives traded on U.S. exchanges are "American" style options. This means they can be exercised at any time prior to the expiration date. However, holders of American-style options generally elect to realize any profits or losses by making closing or offsetting trades because the costs of these transactions are usually much lower than those associated with exercising. In addition, a closing transaction may provide an opportunity for the option holder to profit from any remaining time value (future potential) in the option that would be lost through exercise. At expiration, most option exchanges will automatically exercise an option if the underlying issue's last trade in its primary market is at least $0.05 "in-the-money," unless the holder has issued instructions not to exercise. Once the exercise of an option has been assigned to an option writer, even though he may not yet have been notified of the assignment, the trader can no longer effect an offsetting transaction in that option but must instead purchase (or sell) the underlying interest at the exercise price.
The Options Industry Council, a non-profit association created to educate the investing public and brokers about the benefits and risks of exchange-traded options, provides some interesting facts concerning the topic of assignment. Surprisingly, only a small percentage of options end up being exercised and the ratio hasn't varied much in the past few years. The data suggests that option exercise is relatively uncommon and of those few occurences, most are near the expiration date. That's a very important fact since one of the most frequent questions asked by novice traders concerns the potential for early assignment of in-the-money options. In most cases, the probability of an exercise occurring prior to the option's expiration is relatively low and only when you are short in a position with little or no extrinsic value does the likelihood of an unwanted assignment become a significant concern.
Next week, we'll talk more about option trading fundamentals and review some of the strategies used by conservative investors.