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In all cases, SLM, GM, CELG, and NBIX, we are holding our sold puts, even though all but NBIX are below their strike values. We want to own these stocks, and we may by March expiration. There was only one piece of fundamental news. CELG received an refuse to file (RTF) from the FDA on their prized pipeline drug, ozanimod, designed to treat MS. Dave stated that this will likely set the launch of this drug back approximately a year, but because the RTF wasn’t issued for a safety reason, it will not hurt chances for approval that much. That being said, my personal feelings are that this points to management issues. From a large biotech company, this is usually avoided by constant communication with the FDA and thorough disclosure in the filings. While the CELG fundamental case changes very little, I am put on alert, and I think management needs to prove themselves a little bit here. I would still own CELG at these levels, but am put more on alert.
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So far, we discussed all the essential option characteristics. What an option is, its variables, and how to use options for risk adjustment. So now that you know these things, there are several “goto” strategies that take advantage of the flexibility of options. These are general strategies, and not specific to a trade. When you become a “master builder”, you can use these as a template and use your knowledge of options to alter them slightly to match your expectations.
I will separate them into long-term and short-term strategies. The cutoff for these would be 30 days. That’s when theta kicks in pretty heavily and price changes become predominant instead of volatility, so that’s a good metric. This isn’t to say you shouldn’t use these strategies on either side of that 30-day border, but these strategies typically have a long term or short term focus. Long-Term Options Strategies Buying Naked Options – This is when you just purchase a call or a put. It is the simplest, and probably first option trade you do. More than likely, you lost money on that first trade because you didn’t understand the options fully. I say this is a long term-strategy because if just buying a naked call or put is your strategy, theta will burn you really fast. You may hear people trade “lotto calls”, and they work when they outpace the theta decay. If anyone knows when that will happen, it is a good technical trader. But the most lucrative options trades these traders execute are the trades that originate more than 30 days out. This is because traders see the overall trend, and it is easier for the stock price to outpace theta. Characteristics: Delta positive for calls (negative for puts), theta negative, vega positive, possible return is infinite, possible loss is option price. Selling Naked Options – Traditionally these are considered long-term strategies. I know many options strategists that sell 5-10 delta SPY puts 20-40 days out every day and make 6-10% per month. For the past 7 years it worked beautifully, making them almost triple digits per year. Without a plan, however, corrections will slaughter your portfolio, making all those portfolio gains worthless (if you are curious, they hedge with long VIX calls to cut into their profits by ~25%). In the end, this is a very effective strategy if you have the margin but is also very dangerous if you have no experience. These are prominent in my fundamental newsletter since the premium attached to the options account for more than the opportunity cost of holding that cash in an interest bearing account. Characteristics: Delta negative for calls (positive for puts), theta positive, vega negative, possible return is premium, possible loss is infinite. Cash-Secured Put – I put this under "selling naked options" because it is basically the same thing for puts, but I wanted to describe the strategy separately. If you do not own a security but are sitting on a pile of cash waiting for a security to get cheap enough to buy, you may sell puts in the security at the price you plan on buying at. For example, let’s say you don’t own BMY at $60, but are willing to buy BMY at $55, you can sell a Mar $55 put for $60 per option. For 10 options, that’s $600, 1% gain on that money in a month. Sure beats today’s savings account rates. This is a strategy for the disciplined value investor, who doesn’t try to time the market but understands the company he/she is buying and knows when it is a good value. Characteristics: Delta positive, vega negative, theta positive, trades premium for willingness to buy stock at a certain price. Covered Calls – This is a fantastic plus-up trade for the disciplined long-term value investor. Let’s say you are bullish on BMY and own 1000 shares. BMY currently trades at around $60, and you are going to sell it at $65. You can put in a "good until cancelled" sell order at $65, pocket your 8% no matter how long it takes (including never), and move along. Let’s say it takes a year. That’s a nice return! During that time, however, you can sell 10 $65 calls 30 days out. Right now, that returns about $39 per option. Sell 10 of them, and you made $390 automatically. If the price goes up to $67 at expiration, you have basically sold your options at $65 and made that extra $390 on top of it. If it took 12 months, you made an additional $4680 to the 8% you made above (assuming the stock steadily goes to $65). That’s 7.8%, you doubled your income. Furthermore, you will still make that money if the stock goes down. And that is on a low-IV stock. This strategy is met with mixed feelings in the option world. I like it for the “disciplined value-investor”, because the disciplined trader will sell at $65 and not worry that it went to $67. He/she won’t feel like they lost. If you treat the $65 mark as a “target”, then you might not like the covered call, because as soon as it hits $65 you now have a naked sold call in your portfolio until it goes back to $65 or expires. There is also a question of dividends. Do I owe or receive dividends if I own an option, and the answer is no. But the option pricing will reflect the change in underlying’s price. The only danger with dividends is if the strike price is close to or below the underlying price in the covered call strategy, the receiver of the option may assign on ex-dividend date. Other than that, there’s no change from dividends. Characteristics: Delta negative, vega negative, theta positive, trades premium for capping gains from owned securities. Short-Term Strategies Vertical or Spread – I had a hard time deciding where to put this strategy because it could be long or short term. A vertical is selling a call or put, and leveraging it with a higher or lower call or put price on the same expiration date. One interesting thing about a vertical is that it doesn’t matter whether you use calls or puts, if the short strike is higher than the long strike, it is bullish. Opposite is bearish. You may hear the term “debit spread” or “credit spread”. A credit spread is one where you collect money for the execution. Essentially if you use puts for a bullish spread or calls for a bearish spread, it is a credit spread. The returns only change if the premium is different between credit and debit spreads. For example, a Mar BMY 50/55 put credit spread will yield 9% on your margin, while a Mar 50/55 call debit spread will yield about 8%. There’s no difference between the two, so you do the credit spread! Usually i trade the options that are OTM because they have higher volume. Now if you are perceptive, you may be thinking “Wait, why would I ever do a cash-secured put if I could do a vertical?” If you are strictly an options trader, you are absolutely correct. The amount of margin required for the above cash-secured put is $5500, while the margin required for the 50/55 vertical is roughly $460. You can exponentially increase your returns. However if your short options get assigned, you will be responsible for paying that full amount for the shares. So you don’t necessarily want to increase your spreads by 10 to use the same amount of margin… you can wake up to a surprise bunch of shares the next morning, especially since you can’t exercise YOUR puts before you get a margin call. The most you could lose, however, is the difference between the short and long strikes minus the premium which is why so little margin is needed. Also, because verticals are vega negative, they are a much better play for earnings or catalysts. Do not purchase straight calls or puts for catalysts. Characteristics: Vega negative, theta positive, max gain is premium (for credit spreads), max loss is difference between long and short strikes minus the premium. Max gain is premium. Straddle – Straddles are buying calls and puts at the same strike on the same expiration. This strategy tries to take advantage of short term volatility, but when you have two sets of theta negative trades and diametrically opposed prices that must make up for each other, the price better be really volatile for you to make money on this strategy. Typically this strategy is used as insurance against expected movements, but it is probably the worst way to play any sort of earnings or catalyst. Needless to say, I will very rarely suggest this strategy. You have to have a good idea of how much the market will move before you execute this one, and rarely do I have that kind of insight. Characteristics: Delta neutral, vega positive, theta negative, max loss premium. Max gain is infinite. Iron Condor – An iron condor is basically a bearish and bullish vertical facing each other from different strikes, creating kind of a table in the risk chart. Typically they bracket the underlying price and are a delta neutral strategy. You want the price to not move, as theta works its magic. Another attractive thing about this strategy is that you collect two premiums (bullish and bearish sides) for the same spreads, making the margin even lower. Iron condors are typically only done with 2 credit spreads, so when exercised, it looks like you are “selling” a condor. However, you can “buy” a condor and reverse all of its metrics making a straddle, but I don’t advise it. This is the first in a class of strategies called “Income Trading”, as there are traders who sell a condor and have specific plans two adjust at certain points in the trade to keep theta working. Those adjustments come at a price though, so the goal is to have enough premium to make adjustments and still make money. The following trades are all income trades, but could be used for speculation as well. Characteristics: Delta neutral, vega negative, theta positive, max loss is different between one side’s long and short strike minus total premium. Max gain is premium. Butterfly – This is like an iron condor, except both short strikes are at the same strike price. Typically a butterfly is in the same option class (all calls or all puts). If it involves both options classes, it is called an Iron Butterfly. Those are my favorite trades because you have a lot of premium to work with, and margin required is typically low. Characteristics: Delta neutral, vega negative, theta positive, max loss is different between one side’s long and short strike minus total premium. Max gain is premium. Calendar – If you look back in article 3, you will see that theta is exponentially decreasing the closer you get to expiration. This strategy tries to take advantage of that by selling an option at a certain strike, and leveraging that with an option with a later expiration date (typically a month later). You will also note that IV is higher in out months, because there are more likely to be larger shifts in price the more time you have. Because of that, this is an important strategy because it is a theta and vega positive trade. Because there is more time premium in further out trades, this is always a debit trade. If it is ever a credit trade (except on VIX), I’m sure a computer somewhere would find it before you do, buy it, and exercise both immediately and pocket the nickels. Expiration for the strategy is considered to be the front month. A lot of times you may hear me refer to something called a "campaign calendar". This is when I execute a calendar that is out of the money where the front month is within 30 days and the back month is several months out. If the underlying does not move how I expect because I feel it needs more time, I will wait for the front month to expire, and just sell the next monthly option. So the full scope of the trade plan may take a while, and every front month sold decreases the total capital in the trade. The way you can lose money in this trade is as the underlying price goes further away from the strike price, the extrinsic value goes down much quicker than the theta decay. So the goal is to have the trade migrate closer to the strike price. Characteristics: Delta neutral, vega positive, theta positive, max loss is premium paid (unless held after expiration). Max gain cannot be measured concretely. Diagonal and Double Diagonal – This is basically a directional calendar. The difference is that the front month is sold at a different strike price. It is speculative like the vertical, but vega positive. The double diagonal is essentially an iron condor, but the long strikes have later expiration dates. Characteristics: Delta neutral, vega positive, theta positive, max loss is premium paid (unless held after expiration). Max gain cannot be measured concretely. We already discussed what an option is, and how it can help with risk management. When I was talking about risk management, I was talking about how options require a lot less margin to make the same amount of money on a stock. Why wouldn’t everyone do it then? In short, it is because there are three things to consider when investing in options rather than the single variable in stocks. When you master these three variables however, investing in options is the clear superior investment vehicle. I’m sure you have heard of the “Greeks” when dealing with options and their importance. While they are extremely important, they boil down to a measurement of 3 variables. So I will go over those three variables, then explain how the Greeks are derived from them, and how to treat the Greeks in your trading. While looking at these variables, I’m going to have an example option, and bold the significant part of the options as it relates to the variable to help you follow along.
Stock Price – February AAPL $100 call @ $.89 IV 21.20 The first and most obvious variable is the stock price itself. If you buy a call, and the stock goes up, you will make money. While this variable is the easiest to understand, it is the most important. Your thesis determines how well your trade pans out. There is no way to avoid it, if you are wrong in your thesis, you will lose money. No plan will save you. While that is true, if your plans are well formed you can make money if your thesis is correct only 50% or even 40% of the time. With stocks, you must be right more than half of the time to make significant money. This is reflected in the armies of researchers employed by hedge funds and banks, as knowledge is the traditional edge in the market. Now, markets are driven by speed of trades, liquidity, and pricing inefficiencies. The average retail investor doesn’t have close to the amount of money these hedge funds and banks have. The average retail investor cannot compete with any of that, and is at a major disadvantage in all types of trading because of it. Most retail investors I talk with range between capitulation and treading water when it comes to the market. How can we tip the scales in our favor? Most of you are aware of this, and rely on theses that try to even the playing field just a little bit. Another way is to have plans that limit losses when wrong and have greater gains when right. Options allow you to do this. Implied Volatility – February AAPL $100 call @ $.89 IV 21.20 It is catalyst time. You learn that this PDUFA is going to result in a positive outcome. The stock is at $30, you decide to buy a $50 call for $1. This is going to be sweet! Results come in… FDA approval! You sit down in your desk chair and lean it back resting your feet on the desk. You give your dog a quick pet, you cut your Churchill Romeo y Julieta cigar and light it as you log into your account. The stock is at $45 at 9:45, the option price is…$.75??!!? The stock is up 50% and your option is down 25%? You just got punked by volatility. Implied volatility is simply the demand for the option itself. This demand is driven by the expected movement in the stock. So naturally when there’s a catalyst or earnings expected, the implied volatility is raised. When that catalyst is over, the expected movement decreases as does the price of the option itself as it relates to the underlying stock’s price. This is no reason to fret, in fact, this is an extremely important variable to understand in order to even help your stock positions. Let’s look at the GILD chart as of 2/1, 2 days after the MRK approval of a competing Hep-C drug. Let’s say you knew nothing about GILD. This chart is the only information you have. About a week ago, the IV was at 33, but then IV skyrockets to 60! Then the news hits, Zepatier is approved, the GILD goes from $87 to $83. Along with the news, the IV starts its descent. If you didn’t know about Zepatier, you should have known something was brewing when that IV shot up. This should excite you because all those hedge funds who know more than you do just telegraphed their move! This leads to my number 1 rule for catalyst trading: Always have a short volatility trade (in or out of the money) when the date of it is known. Volatility will always go down when the catalyst is over. This means instead of buying a call when bullish, you sell a put. If you don’t have enough money to sell a put, you can leverage with buying a lower valued put (a strategy called a vertical which I will describe in the next article). There are no exceptions to this rule. When you are selling your house, wouldn’t you rather have 5 people bidding on it than be one of those 5 people doing the bidding? This leads to another question… why don’t all those banks and hedge funds do the same thing? I have spoken to a couple of portfolio managers about this, and their answer is because generally they use options to hedge their positions. So if someone is bullish on GILD but know the MRK catalyst is coming, they just buy puts to minimize the damage since it costs less margin, which is an effective strategy for them. The same is true for overall market volatility. The VIX is a measurement of option volatility in SPX (not the 'fear' index). Since most portfolios lean long, when there’s a sign of downturn the VIX goes up. This is why in general when the market is down the VIX is up, and vice versa. Now that you understand this important aspect of options, you can use it to your advantage and profit greatly from it. It is important to mention the effect of time on IV. Because there is more of a chance for bad things to happen the further expiration day is, volatility has a greater impact. This is important for a calendar strategy that I will explain in the next article. One final small note about IV. The number itself is the relative standard deviation in a monthly move in the underlying. However, when looking at the number I use it on a relative basis. For instance, GILD’s IV at 60 vs. 33 is only good in relation to its historical IV when formulating trades. You need an IV chart like the one above to see if the IV is high or low, and trade accordingly. The option premiums will reflect these numbers, so it is best used when creating strategies to understand how much the underlying has moved historically. Time - February AAPL $100 call @ $.89 IV 21.20 One interesting aspect of options is the expiration date. For all American-style options, the best possible price to buy an option that is exercised immediately would give a value equal to or less than than the stock price + the premium (or reverse for a put). Otherwise some computer would buy that option, exercise, and sell within a nanosecond. Since there is a deadline to reach the strike price, the extrinsic value decreases as time wears on. Time is also not a variable, it is an exponentially decreasing constant, since it doesn't change. When you by a call with 15 days left, something big an unexpected had better happen soon, or time will eat at your option value. But if you sold a put instead of buying a call, that curve is in your favor! You want time to go as fast as possible! I call time (or theta) the house advantage. Why wouldn’t you want to be the house? For rangebound trades, you always want to be theta positive. Greeks So now you know all about the three variables of options. The greeks are a measurement of those three variables, and the values are given by the Black-Sholes model.
Summary Congratulations! You now know enough about options to hold your own in a bar conversation. While this seemingly makes options more complicated to trade, it actually makes them a lot more flexible. You can tip the scales of risk to reward in your favor by understanding how stock price, volatility, and time affect your trade, and align your ideas more closely to your thesis. In the last article, I discussed the basics of options: what they are, their classification, properties, and the different types that exist. I also mentioned how options allow you to speculate on the most expensive stocks at the price of a penny stock. This can make the prudent investor uncomfortable, as penny stocks are classically known as very risky because of the percentage swings and general lack of knowledge about the underlying company. With options the latter issue with penny stocks is solved, because everyone knows who JNJ is, but the swings in market value of options absolutely exist. This article describes how to manage your options to actually control your risk. But before we get there, we will start explaining the pricing of options.
Who determines how much premium an option has? Ultimately the market does. If there is a high demand for a particular option, it will be more expensive. If there is lower demand, it will be cheaper. The CBOE originates a lot of options, so supply is actually not too much of an issue. The CBOE uses something called the Black-Sholes model to determine their pricing for options. The mathematician in me looked up the formula once and punted. Just know that it is based on historical movement of the underlying, and the volume and open interest just increase the demand for the option (also called implied volatility, or IV for short). Wait, what is open interest? My colleague Tony Pelz explained it well a few years ago, and nothing has changed since then. Why reinvent the wheel? The other basic information included in an Option Chain is Volume and Open Interest. Volume is easy to understand: it represents the total number of options traded for each Strike during a day (just as the volume for a stock represents the total number of shares traded during a day). For example, the SEP 16.0 Strike Call volume as of this day, June 2, was 564 contracts (see Exhibit below). This means that 564 contracts (options) were bought/sold during the day. On the same day the SEP 18.0 Strike Call traded 2,192 contracts, the most active strike for this Series. Volume is a very useful metric as it shows where most of the trading action for the day is occurring. Many possible inferences can be made reading daily volume data. Exhibit: Option Chain for XYZ Stock Stock: XYZ @ $16.35 Today: June 2, 2010 SERIES: SEPTEMBER CALLS PUTS BID ASK Volume O.I. STRIKE BID ASK Volume O.I. 2.83 2.88 10 2,114 SEP 14.0 0.59 0.61 455 3,144 2.08 2.13 242 1,071 SEP 15.0 0.83 0.86 247 7,365 1.44 1.48 564 1,389 SEP 16.0 1.19 1.22 306 6,256 0.92 0.96 576 2,267 SEP 17.0 1.68 1.71 1,103 3,633 0.55 0.57 2,192 4,435 SEP 18.0 2.30 2.34 482 1,594 While volume represents the daily activity for each option, Open Interest represents the net increase or decrease in the total number of options traded (opened and closed) since the inception of the Series. For example, the Open Interest for the XYZ SEP 18.0 Strike Calls in the Exhibit is 4,435. This means that a net total of 4,435 option contracts have been opened/remain open since the Series inception. It is important to note that daily Volume does not always equate to Open Interest – that is, just because a day’s Volume was, for example, 500 contracts, it does not mean that Open Interest will increase by 500 contracts. To expand this point, the Exhibit below shows daily Volume, Open Interest and Net Change for the ABC 5.0 Strike Calls. On Day 1, Open Interest was 10,000 contracts – a net total of 10,000 ABC 5.0 Strike Calls have been opened (and remain open). During Day 1, 500 contracts traded. On Day 2, Open Interest is now 10,500 contracts, which means all of the Volume on Day 1 was from new (initial) contracts. On Day 2, contract Volume is 300. On Day 3, Open Interest is now 10,700, a net increase of 200 contracts. This means that of the 300 contract Volume during Day 2, 100 were closing positions and 200 were opening (initial) positions. During Day 3, 1,500 contracts trade. On Day 4, Open Interest declines by 1,500 contracts, the entire Volume experienced on Day 3. Exhibit: Open Interest and Volume ABC 5.0 Strike Calls Volume Open Interest Net Change Day 1 (open) – 0 – 10,000 Day 1 (close) 500 Day 2 (open) – 0 – 10,500 (a) +500 Day 2 (close) 300 Day 3 (open) – 0 – 10,700 (b) +200 Day 3 (close) 1,500 Day 4 (open) – 0 – 9,200 (c) -1,500 Open Interest is a very useful metric as it gives you a snapshot into the money flow in the various Strikes of both Puts and Calls. This can at times allow you to gauge general sentiment in the Underlying shares. In some situations, it is extremely important to actively monitor and interpret Open Interest. I will add to Tony’s description only one more use of Open Interest, and that is to understand the option’s current liquidity state. If an option has an open interest of 0, that doesn’t mean that you cannot trade it; but the only buyer and seller is the CBOE… and they know it. How do I use this information to manage risk better? Let’s piggyback off of Tony’s example above. You expect stock XYZ will go up to 18 by the expiration day in September. Currently the price is $16.34. You also notice the SEP $16 Calls @ $1.46 (midpoint is the usual mark). So you are faced with a dilemma. Should I buy the 100 shares of XYZ and pay $1634 total, or should I buy the call for $146? If you are right, and stock XYZ moves up to $18 at a constant pace (never happens) and ends at expiration at exactly $18… you exercise your options and you just made the same amount of money (minus $146) at a fraction of the margin it took you to just buy the shares. If you wake up one day and the CEO was arrested overnight spending company funds on hookers and cocaine, your loss was $146 with the call. With the actual stock purchase, you have lost up to the full $1634. It could be less, and probably is, but the risk is disproportionate to the reward. With options, you can greatly manage your risk but not putting up any more money than you are willing to lose while having the ability to make a comparable amount of money as stocks at the expense of a small premium. Granted, it isn’t as simple as that since there are a few more things to consider with options that will be explained in the next article. But think about this when making a move on catalysts, earnings, technical plays, or even longer term plans. Options greatly increase your available margin and allow you to make more with less. A quick note about commissions One other downside to options is that the commission structure is much more expensive than trading stocks. Talking babies peddling E-Trade boast $7 stock trades, while options commission structures look like $10/trade plus $1.50 an option. This can add up really fast, but the returns are worth it. Between trading, exercising, expiration, and settlement, you are getting a lot more service for your trade with an option than you do with stocks, so it does make sense. Personally, my favorite platform is thinkorswim.com, and the cheapest commissions with a decent platform is optionshouse.com. In 1973, the Chicago Board Options Exchange began to offer what has become the most popular derivative in the world. Their product is called an option, which is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date (Investopedia). From that day on, the face of the trading world changed. It may be difficult for the average retail investor to cobble together $1000 to buy a share of PLCN and expect reasonable gains, but now all of a sudden you can profit from its price action by buying a $75 call! It essentially turns even the largest of companies into a penny stock!
For the classical investor, options can be intimidating. You basically own an agreement to own something, which in itself has little value. In addition, if you don’t understand all the variables that go into understanding what you have, you can easily lose money and become disenchanted. Lucky for you, I’m here to decode this mysterious but highly lucrative product for you. What is an option's value? The classic stock option agreement is for 100 shares of a stock at a certain price (called a strike price) by a certain time (expiration date). These options are sold at a price completely determined by the options free market; supply and demand. That price is split into two parts… intrinsic value and extrinsic value. Intrinsic value is the amount the option is worth if exercised immediately, and extrinsic value (also known as premium) is the amount you expect to be realized by the expiration date (otherwise you wouldn’t buy it!). As an example, PCLN is currently trading at $1043. A Feb. $1000 call option is selling for $75. The intrinsic value is $43, the extrinsic value is $32. If an option has any intrinsic value, it is called “in-the-money” (ITM). Without any intrinsic value, it is simply “out-of-the-money” (OTM). Can I play both directions with options? Absolutely! You can buy a bullish option known as a call. This would be an agreement to buy 100 shares of a stock at a certain price. You can also buy a bearish option known as a put. This is an agreement to sell 100 shares of a stock at a certain price. Furthermore, you can also sell calls and puts! So selling a call option is a bearish move, and reverse for a put. I will explain the advantages to each of these choices in a later article. When can I exercise my option? Exercising an option means to put the agreement into effect. There are two types of exercising options, American style and European style. American style means you can exercise whenever you want, as long as it is before the expiration date. European style options settle on the expiration date no matter what. American style options are done at the buyer’s will, so if you sold a put and the stock is above the strike price, you cannot just “exercise” it and collect your premium before the option is in the money. However, you can sell your obligation at the price the market dictates in the secondary market. This is the route most buyers take. In fact, according to the Options Clearing Corporation (OCC), in 2006 only 17% of options actually were exercised. (see table below). Stock options are typically American style. If you plan on holding options for a long time it would be good to know what kind of option you are holding. The last thing you want is to wake up one Monday short 100 shares of a call option you sold! When the expiration date comes, ITM options are automatically exercised and OTM options expire worthless. On expiration day, options are either “AM-settled” or “PM-settled”. An AM-settled option’s settlement price is the opening price on the next trading day. PM-settled means the settlement price is the closing price of the stock on expiration day (technically 15 minutes after the close, actually). The typical monthly stock option is “AM-settled” on the third Friday of the month, and weekly stock options are typically “PM-settled” on Friday. Most of the time I don’t advise holding an option until expiration for reasons I’ll discuss in later articles, but this is important to know. When can I trade my option? Almost all options are traded during market hours only! This means there is risk in holding options overnight. This is extremely important when trading options, as you could stand to lose a lot of money without the ability to mitigate losses if something happens in the after-market or pre-market. What is the impact of dividends on my option? Technically there is no impact of dividends on an option itself. There are some impacts, however. First, theoretically, when an equity goes ex-dividend the stock is supposed to decrease by the amount of the dividend. This is sometimes priced into the options, sometimes it is not. Further, with American-style options, when holding options in the money, sometimes institutional investors will exercise the options in order to capture the dividend in an arbitrage that is close to risk-free. The moral of that story is, do not hold short ITM calls into an ex-dividend date. Summary Options are a fantastic vehicle for anyone who wants to trade future movement of stocks, or markets in general. They are tremendously flexible and have the capability to accelerate your gains while controlling your risk. It is important to know what you are buying, and to know what you are getting into. Hopefully this article helped you understand your option contracts a little better. In future articles, I will talk about risk management with options, the variables involved with options, I’ll introduce you to the “greeks”, and common option strategies. This will lay the groundwork for my mission as The Wizard of Ops, which is to optimize your trading strategy. |
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