Options are complex derivatives, impacted not only by the price action of the underlying security (stock, bond, commodity, future, index, ETF, etc.), but also by the passing of time and changes in implied volatility (IV).
While options are more complex instruments, they offer improved probabilities of profit (POP) far exceeding what can be achieved with equities and futures.
In Part 1, we will cover the Option Contract, Assignment and Exercise, and American and European style options.
Every option contract has a buyer and a seller. Buyers of options are considered Long a position, while Sellers are considered Short a position.
Stock and Index option contracts have a 100x multiplier. This means each option contract controls 100 shares of the underlying.
An option contract gives the buyer of the contract the Right, but not the obligation, to buy (for a Call option) or sell (for a Put option) 100 shares (per contract) of the underlying at a specified price (the Strike price) during a specified period of time (days till expiration of the contract).
And conversely, the seller of the option contract is Obligated to sell (for a Call option) or buy (for a Put option) 100 shares of the underlying at the strike price during the term of the option contract. Once the contract expires, this obligation disappears.
When is the Seller obligated to perform?
Exercise and Assignment
A Seller is obligated to perform only when the Buyer exercises his right under the contract. At this point, when the Buyer exercises his right, the Seller is then assigned and thus obligated to perform (performance is automatically completed by the Broker).
The Buyer generally exercises his right when the underlying price exceeds the strike price of the option (which is referred to as being in-the-money, ITM), and it’s near expiration (generally within the last week). If the price of the underlying does not exceed the strike price of the option (referred to as out-of-the money, OTM), then the Seller keeps the premium paid by the Buyer.
Both the Buyer and the Seller can close (or exit) their contract at any time prior to expiration by offering the contract to other buyers and sellers in the marketplace (on the exchanges trading options). It is NOT required for either Buyer or Seller to hold a position (or contract) till expiration.
American and European Style
The above described an American style option, in which the Buyer can exercise his right at any time prior to expiration. However, there is another style option, the European style.
There are four key differences between to two styles.
First, most optionable stocks, futures, and ETFs (exchange traded funds) are American style. Except for the S&P100 index (OEX), all other broad-based indices (SPX, RUT, NDX) are European style.
Second, American style options typically expire at the close of business on the 3rd Friday of the expiration month. For the Weekly, expiration occurs each Friday at the close of business. For European index options, expiration occurs the Thursday preceding the 3rd Friday of the expiration month.
Third, Settlement price is the official closing price and determines if the option expires ITM or OTM. Any option that settles for 1 penny or more ITM will automatically be exercised. For American style options, since they expire on Friday at the close of business, the Settlement price is the last traded price during business hours (after-hours trading does not count). For European style index options, the Settlement price is determined Friday morning, after all stocks within the index have opened (the opening price). When this occurs varies, and the official Settlement price is not published till hours later.
While non-index underlyings settle for stock, index underlying settle for cash.
And fourth, as mentioned earlier, American style options can be exercised at any time prior to expiration; European style options can only be exercised at expiration.
A note of caution: the settlement price of an American style options is seldom surprising. At the close, if the underlying closes at 50.25, then you can expect that your 50 strike Call will expire ITM, while your 50 strike Put will expire OTM. However, since European style indices Settle the next morning, there can be a surprisingly big difference between the prior day’s closing price and the settlement price. This is why it is prudent to close your option position prior to the close on expiration Thursday.
In conclusion, when trading options, understand both your rights and obligations, and the differences between expiration and settlement values (especially for index options).
For more information on options and earning consistent weekly income trading options, go to OptionsAnnex.com.