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Educational Article

EXERCISE CYCLES Dont Worry, Its Not What You Think

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Well, those of you who know me, know my definition of exercise is the quarter hour dash from the couch to the refrigerator and back. If that was an Olympic event, Id win a gold medal. However, options are a little different. Lots of money involved, but no calories. Today were going to examine exercising options and also option cycles. So, never fear, no perspiration is required.

Option Exercise / Assignment
As we discussed in previous columns, most people who trade options want to take advantage of leverage. Their objective is to pay little to control an asset and then, if the asset moves in the desired direction, to sell the option and make a magnified percentage on the option. Theyre betting on the movement of the asset. They really have no desire to own the asset itself. The terms exercise and assignment both mean essentially the same thing. It just depends on which side of the transaction youre on.

Remember, when you buy a call, you have purchased the right to buy shares at a particular price. If, for some reason, the trader actually wants to buy the stock, he notifies his broker that he wants to exercise his option and to purchase the stock.

The person who originally sold the option has therefore been assigned. He has to live up to the obligation he took on when he sold the option. In the case of the call option, he has contracted to provide a certain number of shares at the specified strike price.

When you buy an option, and the stock moves well beyond the strike price, it will require an action on your part prior to expiration. Likely, you will simply sell the option back to the market and take a nice healthy profit. However, if no action is taken, your broker will assume you want to exercise your option and will do so. You may not have sufficient funds in your account to purchase the stock. You can get into some deep _ _ _ _ (trouble)! So, its important that you have a good understanding of exercising and the assignment of options.

Some traders play the very dangerous game of selling uncovered (naked) options. These traders are taking on substantial, and often unlimited, risk because the sold options are not hedged in any way. When a trader sells an uncovered call, he is betting that the underlying asset will finish (at expiration) below a specific strike price. Conversely, when a trader sells an uncovered put, he is betting the underlying asset will finish above a specific strike price.

Example A: XYZ stock is trading at $38. The trader believes XYZ will finish below $40 and sells the $40 strike price and takes in a premium of $1.50. If XYZ, at expiration, closes below $40, the short (sold) call will expire worthless and the trader will retain his $1.50 profit. But, what if XYZ rallies to finish at $46? The trader has an obligation to provide shares to the option buyer at $40. That means he has to go out into the open market and purchase shares at $46 to satisfy his obligation. He bought the shares at $46 and sold those shares at $40 a $6.00 deficit. He had taken in $1.50, so he has incurred a loss of $4.50.

Example B: ABC stock is trading at $52. The trader believes ABC will close above $50 and sells the $50 put, taking in a $2.10 premium. If ABC, at expiration, closes above $50, all is right with the world, the short put expires worthless and the trader keeps the $2.00. However, if ABC falls to $39, the option seller has to satisfy his obligation to buy shares of ABC at $50. That represents an $11 deficit. He took in $2.00 of premium. That translates into a net loss of $9/share.

Trading uncovered options requires meeting certain experience, and often account-size, criteria. Dont even think about it. At this point, this is for informational purposes only.

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Option Cycles
Stocks that are optionable will always have options available for the current month and then for the very next month no exceptions. If its April 1st, there will always be options available to trade for the April cycle and the May cycle. Once the April cycle is over (after the third Friday in April), May becomes the current cycle and June options will be available.

What additional option months are available to trade beyond the current and subsequent months? That depends on the underlyings option cycle.

Every optionable stock is assigned an option cycle. Each option cycle consists of four option months spread out over the year -- the January Cycle, February Cycle, and March Cycle.

The January Cycle includes the months of January, April, July, and October. That means that, regardless of the date, those option months will be available to be traded. Similarly, the February Cycle includes the months of February, May, August, and November. The March Cycle includes March, June, September, and December.

So, when you look at a complete (all months) option chain, you will be able to immediately recognize which option cycle has been assigned to a particular asset.

An Exception: Many optionable stocks (but not all), especially the more liquid ones, will have what are called LEAPS options. LEAPS is an acronym that stands for Long-Term Equity Anticipation Securities. LEAPS are just long term options up to about 2 years out that are available for trading all with January as their expiration month.

At this writing (September, 2006), some stocks have LEAPS going all the way out to January of 2008. In June, some stocks will be offering LEAPS going out to January of 2009. The point is, on all stocks having LEAPS, there will be January options offered for those years regardless of the option cycle assigned to that particular stock.

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This Is Good Stuff
Just a reminder that, if youre new to options, these basic articles are valuable. Print these articles out so you can reference them at your leisure. This is your bible for the options basics. Its information you need to know before you risk your hard earned dead presidents and it may very well become a collectors item. What better reasons can there be?

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Mike Parnos - A Little Knowledge Goes A Long Way
The outspoken Mike Parnos has been writing Option Investors very successful Couch Potato Trader column for over four years. Hes been trading and teaching options for over 15 years and knows what you NEED to know to trade options profitably.

Too many traders trade the more advanced option strategies without having a good understanding of options, how they work, and how they are meant to be used. The results? Say goodbye to your money. That is why there such a stigma attached to options. And thats a recipe for disaster. If you have more money than you know what to do with, losing $5,000 or $10,000 is no big deal.

However, if youve worked hard for your money, and you appreciate the value of a dollar, you should make every effort to learn everything you can about options before you put your money at risk.

Mike tells you like it IS, not how you hope it will be. As you read through the columns, feel free to send him your questions at support@optioninvestor.com, with Options 101 in the subject line.

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