7 - Option Basics - Option Cycles
OPTION CYCLES
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, I'd win the gold medal. However, options are a little different. Lots of money involved, but no calories. Today we're 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 directionally 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. They're 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 you're 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 shit! So, it's 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. Don't 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 it's 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 underlying's 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 ½ years out – that are available for trading – all with January as their expiration month.
At this writing (April, 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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Last Week's Quiz Results
So, how did you do on last week's quiz? Honestly. Did you even take it? Here are the answers to the quiz. I promise there will be more. Read, study, absorb like your options financial survival depends on it. Because it does.
1) Right, obligation, expiration date, strike; 2) Right, obligation, expiration date, strike; 3) Leverage; 4) Hedge; 5) defined; 6) underlying asset; 7) time erosion; 8) True; 9) False; 10) One; 11) Friday; 12) $5.00; 13) $5 increments, then $2.50 increments below $25; 14) $5.00; 15) Ask Price; 16) Bid Price; 17) Market Maker; 18) Month; 19) Strike Price; 20) Contracts, open: 21) $.50.
(If you have any questions, feel free to email Mike at: mikeparnos@comcast.net)
