Ron Ianieri asked:


The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence as was used in the selection and management processes.

Looking at the closing out of a vertical call spread, we find there are three possible outcomes that must be addressed. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In this scenario, in order to close out the spread, one would just let it expire. Both options finish out of the money so no residual position will be left over.

If the spread finishes fully in the money, (at maximum value) that is with both options in-the-money, then both options will be exercised. You will exercise your long call and your short call will be assigned. They will cancel each other out and you will be left with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.

The difficult scenario is when the stock closes in between the two strikes of the spread. This scenario, the closing of the stock between the two strikes creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money.

When both options expire in-the-money, they are both exercised-one creating a long stock option, the other creating a short position thus canceling each other out. This is not the case here. Here, one option, the one that is in-the-money will leave a residual stock position and since the other option is out-of-the-money, it will not be able to be used to offset the residual stock position created by the expiring in-the-money option.

There are two actions that could be taken. Choice number one involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. Giving up a portion of the profits may be the best thing to do in order to avoid naked, unlimited risk.

If you only trade out of the in-the-money option, you run the risk (albeit short-lived because you are doing this late on expiration day of the expiring month) that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. If that happens, you will now be naked the residual stock position. Of course, if there is still time, you could always trade out of the option then but that is very risky. However, if the stock is at a relatively safe distance from the out-of-the-money you may want to just close out the in-the-money option and let the out-of-the money option expire worthless.

The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this is being done at the very end of the day on expiration day. These options only have minutes of life left. So, knowing this, the risk is somewhat mitigated, but still there none the less.

The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, you would be best advised to trade out of the spread entirely.

Again, as stated before, if the stock closes either with the spread fully in-the-money, or fully out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position. We discussed above how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.

Then, if you have 10 July 50 calls and you exercise them you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.



Raymond

Asoka Selvarajah asked:


Options Trading has a reputation for being extremely risky, but this reputation is in large part undeserved. True, option trades are extremely risky - even dangerous if you have no idea what you are doing. However, that is true of all forms of offline or online trading, and trading in options is no exception.

While options trading has this reputation among laymen, it is often considered to be a form of risk limitation with professional traders. After all, in what other form of investment can you guarantee the maximum loss you can suffer right at the point where you enter the trade?

Options are contracts that give the purchaser the right to buy or sell an underlying security, such as a stock, a bond or a commodity, at a fixed price and for a fixed time period only. You can find options on underlying securities such as stocks, mutual funds, bonds, commodities, and more.

Option trading gives you the chance to exploit a whole range of market opportunities that are unavailable with conventional online stock or forex trading. For example, one class of option trade allows you as the buyer to make money if you expect the market to move strongly in one direction or the other, but you are not sure in which. If you are the seller of position, by contrast, you are betting that the market either goes nowhere directionally and/or the volatility declines.

Trading in options can actually lower your risk. For example, whenever you buy an underlying stock, there is always the extremely small, but non-zero, risk that the company can go bust and the stock price can first be suspended and then go to zero. That means that your potential loss is the point difference between the price you entered the stock trade and zero, multiplied by the number of shares you own! If you had done the corresponding option trade by contrast, i.e. buying call options on the stock, your loss would be simply the price you paid for the options.

Where options are very risky is where untrained traders go “naked short”, as it is called. In one common example, they sell put options on a stock index future and collect the option premium as payment. This gives the buyer the right to sell the stock index future back to the put option seller at a fixed price, called the strike price. This is fine as long as the underlying index continues to rally and the strike price is basically never reached. However, in one famous example, one hapless option punter, who had been happily selling put options on the FTSE index futures for years and collecting the cash, got badly caught when the entire stock market crashed in 1987, and the option buyers exercised their right to sell their positions at prices much higher than the current market!

However, such foolishness apart, option trading can be an extremely profitable way to trade in stocks, forex, bonds, currencies or whatever. When used properly, they can actually limit your risk drastically. Option trading can allow you to create positions and exploit market opportunities not otherwise available. Best of all, if you combine options with the underlying instrument, you get to create a whole range of interesting risk profiles.

The key to success in option trading is, as with anything else in life, to study the subject hard before trying to trade and, if possible, begin by paper trading the market. Once you are satisfied that you know what you are doing and have a valid option trading methodology, then you can begin risking real money. Even then, you only trade very small to start with and with money that you can afford to lose. Once you know what you are doing, and your account size show some nice profits, then you can afford to trade progressively larger size for progressively larger profit.



Nathan