Option Investor
Educational Article

Putting the Cart before the Horse

HAVING TROUBLE PRINTING?
Printer friendly version

The CBOE, Chicago Board Options Exchange, offers an educational "Ask the Institute" weekly column. Questions submitted to that column indicate that some traders attempt to think through all the permutations of options trading before placing a trade. However, other questions received on that site and ours prove that some options traders put the cart before the horse. Let's talk about some basics that put the horse first and the cart behind the horse, where it belongs.

On August 20, 2007, a would-be options trader asked, "Once I'm in an option trade and I want get out of the trade either to take a profit or cut my loss, what do I do?"

This is the ultimate cart-before-the-horse question, but presumably this writer was asking the question before entering a first option trade. The appropriate answer of course was that traders could offset their open option trade by selling a long put or call or by buying back a short one. Check with your broker for the appropriate terminology on your brokerage's site, but some commonly used terminology for opening and closing options trades are found on the "Options Order Form" on the BrokersXpress site. These are "Buy to Open," "Sell to Open," "Sell to Close" and "Buy to Close."

Most beginning options traders are buying calls or puts, so their initial transaction will be a "Buy to Open" order. To close the position, either to limit a loss or collect a profit, traders would then "Sell to Close" the option. Order forms on some brokerages just detail whether the option is a sell or buy order, without detailing whether it’s to close or open the position. Other order forms on other brokerages might use an acronym such as "STC" for a "Sell to Close" order. Each brokerage differs, so beginning options traders should familiarize themselves with the way it's done on their brokerages. Most online brokerages offer tutorials these days.

Other specifics of orders include conditions such as whether the order will be a market order or a limit order, a day order or a good-until-cancelled one, and other such parameters, and the tutorials offered by online brokerages will also cover those permutations, including more advanced orders. In order to avoid putting the cart before the horse, traders should be familiar with all the types of orders offered by the platform on which they're trading.

In addition to asking about orders, questions by new options traders also concern whether their options are cash-settled options. On September 15, 2008, a trader wrote the CBOE, "How do I know which indices are cash settled or assigned stock if the options are exercised? I know the OEX is cash, what about the rest?"

Companions to this question were questions to "Ask the Institute" on January 15 and April 21, 2008. These questioners asked, "What happens to options on expiration that are in the money? Do I need to act or are they sold or converted automatically?" and "When holding in the money [sic] option till expiration, on expensive stock like GOOGLE, with not enough funds to exercise, what happens to it, [sic] does it get settled or cash?"

Writers on Option Investor often receive similar questions. I'd add another frequently asked by new subscribers: Which indices have options that stop trading on Thursday of option-expiration week and which continue to trade through Friday?

The problem with these questions is that they're not always coming from would-be traders learning as much as they can about options before trading. Such questions have sometimes been directed to Option Investor only minutes before an option stops trading by a trader who has an open position.

Key to understanding these questions is an understanding of when an option is in the money. A call is in the money when the underlying trades above the strike price of the call. A put is in the money when the underlying trades below the strike price of the put. For example, a $15 strike call option on imaginary stock BRBR is $0.10 in the money when BRBR trades at $15.10, $0.10 above the $15 strike. A $15 strike put would be out of the money with BRBR at $15.10, but would be $0.10 in the money if BRBR trades at $14.90.

The short answer to these questions about what happens to in-the-money options is that the CBOE offers specifications for each type of product. This includes specifications on "Equity Options," "Index Options," "Options on ETFs and HOLDRS" and others. Click on the "Products" tab at the top of the CBOE's main page at Link to CBOE, and you'll find each type of options product listed. Specifications include when each type of option stops trading; whether an option is cash settled or settled by delivery of underlying stock, ETF or HOLDR; and whether the exercise style is American or European.

Before trading any type of option, traders should verify these specifications for themselves. However, general rules are that options on individual equities, ETFs and HOLDRs are settled by the delivery of stock in the underlying equity, ETF or HOLDR. Options on U.S. indices such as the Russell 2000, OEX and SPX are cash-settled.

For example, imagine that a trader bought a single call on imaginary equity BRBR at the $15.00 strike price and BRBR closed at $15.15 on the Friday of expiration week. Imagine that the trader had not offset that call by a sell-to-close order. That trader's brokerage would likely automatically exercise that call order and deliver 100 shares of BRBH at $15.00 to the trader's account unless the trader had previously alerted the brokerage not to do so. The account would be docked $1500 plus commissions for that 100-share purchase.

Contrast this to the case of a trader who bought an October OEX put at the strike price of $450 and did not offset that put purchase by selling to close the put. That trader's account would have been credited with $101 ($1.01 x 100 multiplier) minus the commissions the trader's brokerage charges, since that put ended up $1.01 in the money. The OEX is cash settled.

Traders might not want to be assigned stock if a call ends up in the money and might not want to put stock to someone if a put ends up in the money. This harks back to that April 21 question to "Ask the Institute" about what happens if a trader is assigned an expensive stock such as Google when a Google call ends up in the money. If that trader has not offset that call before the close of trading at expiration and it ends up even $0.01 in the money, the Options Clearing Corporation rules require that the option be automatically exercised unless that trader has provided a "Do Not Exercise" notice. This would be true of a put position, too, with the trader then "putting" stock to someone. Brokers should be able to advise traders how to obtain and complete such notice. This can be particularly important if the underlying stock is zigzagging just above and below the strike of the option a trader owns. Some traders elect to sell to close such options to avoid any chance that the option will end up in the money.

In fact, many traders also elect to do so well before option expiration if an option is deep in the money, and if the option is trading with little extrinsic value. The extrinsic value is the portion of the value that remains after the in-the-money portion of the options price is subtracted. For example, on October 24, 2008, INTC closed at $14.28. A pricer feature on BrokersXpress priced the NOV 14.00 call at $1.17. The call was $0.28 in the money. That call had an extrinsic value of $0.89. With an extrinsic value of $0.89, the risk of assignment of stock is low. However, as option expiration moves closer, the extrinsic value in an in-the-money option shrinks and the risk of assignment grows. Traders should check with their brokers for advice on whether to hold an option if its extrinsic value has shrunk to pennies.

Option traders who sell equity calls must also be aware of dividend record dates, too. Sometimes a sold call might be exercised unexpectedly, when it still has extrinsic value that seems safe, so that the buyer of the call can collect that dividend.

What happens if a trader is assigned stock because a call ends up in the money at option expiration or if that trader is exercised on a put that ended up in the money and that trader is suddenly short stock? If the trader doesn't have enough money in the trading account to pay for the suddenly purchased stock or to be held as maintenance against the stock the trader is suddenly short, a margin call will be issued. The trader would have a certain number of days to meet that margin call, a number of days that may differ in different brokerages. Check with your broker about specific rules. At most brokerages, traders have time to sell the assigned stock or buy the stock the trader is short and for the transaction to clear in time for the margin call to be met. However, if a trader must sell that stock into a declining market or buy it in a rising one, losses may be incurred. If there is not sufficient account equity to cover that loss, the trader would have to meet the margin call another way, such as by depositing more money. It's best to avoid unintended assignment altogether. Check with your broker for specific rules before you hold an equity, ETF or HOLDR option into option expiration or beyond the point when it's deep in the money, when extrinsic value shrinks and risk of assignment rises.

Not all options can be exercised before option expiration. The XEO, for example, is the European-style version of OEX options. These options can be exercised only on the last business day before expiration, usually the Friday of option-expiration week. OEX options are American-style and can be exercised at any time. SPX, DJX, RUT and other U.S. indices have European-style exercise, like the XEO. Options on most U.S. indices stop trading the Thursday of option expiration week (other than when holiday schedules change option-expiration schedules), but all OEX options, both OEX and XEO versions, trade through the Friday of option expiration.

Traders who do not close out option positions on the U.S. indices that stop trading on Thursday are subject to Friday morning settlement values. A big mistake of many newbie traders is assuming that the settlement values will be close to the values at the close of trading on Thursday afternoon. That's just not always true. Settlement values for those index options that stop trading on Thursday of option expiration week are not the value of the index at the open on Friday morning. Instead, settlement values are calculated from the opening value of each of the component stocks of that index. The components may be opening in a staggered fashion, and if markets are headed up or down as each component begins to open, the settlement value may be well below or above the settlement value of the index itself. OEX settlement values are calculated using the closing value of each component stock on the last day of trading of those options.

Before options trades are entered, traders should know when the option stops trading, whether an option is cash settled or settled by a stock transaction, and how settlement values are calculated. Then hopefully, charting and other skills will lead that horse and cart into profitable roadways.

Options 101 Archives