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Misconceptions that will not go away

One of my basic jobs as an education blogger is to field questions from investors who don’t quite get how options work and explain situations in terms they can understand. This is something that I believe I do very well and it’s the reason I prefer to work with people who are in the early stages of their trading career.

However, I do occasionally receive the same or similar question from the same reader. That means that I have failed to do my job, or I have encountered someone who simply does not understand. It’s true that options are not for everyone, but I thought that refers to people who decide that the advantages of using options are not sufficient to overcome the required sacrifices.

Mark,

I thought you did an excellent job of explaining writing covered calls. Still, I am so confused now I almost do not know how to phrase my question. I will try.

1. When I bought a call position on an underlying stock, and the stock price exceeds the strike price and the cost of the option, regardless of time remaining, am I in the money?

2.When I want to sell (to close) my call position, what price do I receive? The bid price?

A note: I have been trading stocks only for 4 years and am up 90%. I am now studying these options but am unsure, scared actually of the bid and ask prices fooling me – even when I correctly select a rising stock price level. So maybe my question is: is it possible for a stock to exceed the cost of the call option+ premium and by option expiry still not make money?

Craig

Craig,

There is a cry for help in your questions. I get your frustration. However, I need your cooperation.

If you don’t know that you can sell at the bid price, how do you trade? That is so basic. You have been trading stock for four years? Really? When you sell stock, do you sell at the bid price? Options are no different.

Somehow you missed the boat. Wherever it is that you learned about options, it has failed you. You came away from your education with wrong ideas and essentially ZERO understanding of how options work. Sure, you know that buying call options may lead to profits when the stock rises, but that’s not enough information.

Let’s see if I can help with a brief reply. You are going to be asked to forget what you believe and to believe something different. Can you do that?

To begin, a covered call is an option you sold. Your question concerns an option you bought. That is an entirely different situation.

1) Forget the price of the option. Forget the premium paid. If the stock price exceeds the strike price of a call option, then yes, the option (not you, but the option) is in the money.

The cost is 100% irrelevant. I explained that earlier.

An option is in the money (ITM) when the option has intrinsic value. A call option is ITM when the stock price is higher than the strike price. A put option is ITM when the stock price is below the strike price.

Please note: The option premium (price paid for the option) is not part of the definition. The term ITM is a definition. It compares only two things: stock price and strike price. Option cost is not part of the definition. Profitability is not part of the definition. You are asking about profitability on one hand and ITM on the other. They are NOT the same thing.

It’s very simple: If you can sell your option for more than you paid, you have a profit. This is no different from trading stock. It’s not necessary to add this to that and arrive at a sum. It’s not necessary to add premium to strike price. All you have to do is compare the cost with the proceeds.

2) Yes. You receive the bid price. However, you are not obligated to accept that price. You may try to get a higher price. How do you do that? Just ask.

Enter a LIMIT order to sell, stipulating the LOWEST price that you will accept. Sometimes that limit order is not filled because no one is willing to pay that price. But it does not hurt to ask. Thus, If the market is $4.00 bid and $4.30 ask, you can try to sell at a price above $4. In this scenario, I suggest asking $4.10. Don’t ask $5 and expect to get anyone to pay that.

Set your limit price above the bid price, but less that midway between the bid and ask prices. In my example, that would be $4.15 or less. That’s why I chose $4.10. If no one wants to pay $4.10, after five minutes you can always lower your limit price to $4.00.

3. Why do bid and ask prices scare you? Stocks also have bid and ask prices. Do you know what you are doing when trading stock? If yes, options trade the same way. The products are very different, but each trades on an exchange, each had bid and ask prices. Why do options frighten you but stocks do not?

4. As to your last question. The answer is no, assuming you meant to ask if the stock price exceeds the strike price plus the premium paid for the option. In that scenario you earned a profit (it may be very small).

But you are misguided when it comes to options. You clearly got off on the wrong foot, did not learn anything practical. You seem unable to get rid of misconceptions that hurt becasue they result in your looking at specific situations in a strange manner.

Suggestion

Start all over. Find a different place to learn. Perhaps a different book (try The Rookies Guide to Options), perhaps some free webinars from your broker…Do something different. Pretend you know NOTHING and begin again.

Advice: When you buy an option, there is no reason to hold it to expiration. In fact, that is a very foolish thing to do.

You bought the option when you wanted to buy it. So why would you consider selling at any time OTHER than when YOU want to sell? Why would you hold to expiration and accept that as a randomly chosen selling time? Don’t do it.

Options have time decay. The longer you hold, the more it costs. Thus, sell the option when you no longer want to own it. Sell the option when you believe the stock is no longer moving higher. Sell the option before expiration and you will not lose all of the time value.

954

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Danger: Using one trade to finance another

This is a continuation of an ongoing discussion in the comments section. It all refers back to a post from July 2009.

It began with a comment on this post where Mr X (who manages other pepole’s money) proposed the idea of buying a more useful put (i.e., one with a higher strike price) when constructing a collar. Because that ‘better’ put is more expensive that the traditional put (some small number of strikes out of the money) he included the suggestion of financing that more costly collar by selling a put that is farther OTM than the put owned.

In other words, instead of buying a put that affords 100% protection (after paying the deductible) for the other part of the collar (the long stock/short call portion), he proposed buying a put spread. The idea is to buy an ITM put and sell a put that is 20 to 30% out of the money. He provided statistical data that shows that this was sufficient protection more than 99% of the time. That is reassuring evidence for a trader, but the investor who wants the complete protection of a true collar (think Black Swan), this may not be sufficient protection. It is, however, a reasonable choice for someone to consider.

Quoting Mr X:

So you can actually buy a vertical (buy PUT at the money, sell a PUT 20 to 30% lower). This reduces your protection (can still have a major black swan though), but historically it still protects you against 99% of the market drops. And the cost is cheaper (we are saving 20-30% or so on the cost of the protection).

Bottom line: less costly collar, good enough to work 99% of the time (looking back in time does not mean the same results will occur in the future). As I mentioned: a reasonable alternative. The trade is made for a good reason: It costs less, adds to profits (lower cost = higher profit), and is good enough almost all the time. It’s a very attractive idea – for the more aggressive trader.

Summary

The trader has two choices:

  • Own the traditional collar with an (perhaps 5%) OTM put
  • Own a collar with zero deductible (ATM put)
    • This comes with no Black Swan protection

This was my reply at the time:

Overall, I do like the idea of owning the ATM put. But this will not satisfy everyone’s comfort zone. Is it better to avoid the 5% deductible and give up black swan protection? Not an easy decision.

And that was where we left it. An alternative that works better than the collar most of the time, but which leaves the investor facing the possibility of a financial disaster if a true Black Swan event occurs.


That discussion was re-opened recently when a reader commented on the ideas of Mr. X.

One thing led to another and the discussion reached a level where I felt it necessary to post this for other readers.

It is easy to fall into trading traps, and the one discussed by my correspondent is one of those slippery slopes that can lead to blowing up an account. Below is an abbreviated version. The original comment is here

In my mind, this is the progression of a trader:

Step 1: One learns about a put, so they’d like to purchase a put to protect a long position.

[MDW. This trader is off to a very bad start. Learning about puts is not a good reason to buy them. And this really upsets me. One does not BUY or SELL something that is not yet understood. Puts are too expensive for most people to own. It essentially kills any chance to earn profits.

Step 2: To help finance the put, they sell a call, thus they have a collar. They’re willing to part with the stock at the call strike.

MDW: True, it’s a collar. But look what you just did to this poor trader who owned some stock. He ‘learned about’ puts and bought some. Then he sold calls to create a collar. We don’t know that this trader wants to own a collar or even knows what a collar is. This is blind trading for no reason. You are suggesting that this is a ‘step’ in becoming a good trader: Buy a put because the trader learned that they exist (why did he buy and not sell?) and then sell calls just because the trader owns stock and is willing to sell. Two foolish trades. Two steps backwards in an options education. I don’t like being so hard on a loyal reader, but this is not progress.]

Step 3: Like in step 2, they want to help finance the position, so they think of selling a put on the same stock. (this is where you and I agree that this may not be a good idea)

[MDW: I don’t see how this is progress. If the trade is made ONLY to finance the original trade, it is foolish. The discussion you are quoting does not adopt this strategy. Making trades for the sole purpose of raising cash is the (short) path to eventual ruin.]

Step 4: They realize that selling a put on the same stock may not be a good idea because they don’t really want to own it at that strike price.[MDW: Why does the prospect of buying stock at the put strike price occur to you? Not every put seller wants to buy stock. Most traders would cover the put at some future time, rather than take ownership of the shares. There is no indication that the put sale was made for any other purpose than making a trade: Give up the regular collar with its deductible and trade it for a collar with no deductible, but only limited protection. Why is that bad? When I agreed with you originally, I missed the point that Mr X was buying a better put.]

Essentially, they want to sell the put for the wrong reasons and they’re exposed if the stock drops below that lower strike (I think this is where we’re agreeing). [MDW: Not when you explain it this way. In fact, this trader has an excellent reason for selling the put. It lowers costs and leads to profits >99% of the time. What better reason does a trader need, as long as he keeps risk under control by trading the appropriate number of contracts?]

Thus, they try to think of other ways to finance.

[MDW: Why do you believe the trader is seeking other ways to finance? He found a perfectly acceptable method]

Perhaps they could just use existing funds they already have, or they could use the premium from other positions that they would like to own, like by shorting puts on stock B which they are intending to invest in.

[MDW: This trader does not seem to be someone who has any interest in buying any stocks so why would he want to sell puts on stock B? Selling them just to finance another trade is a very poor idea.]

So that’s my thought process of how one gets to this point. The journey doesn’t seem that unreasonable even if individual steps may be ill-advised (i.e. step 3).

[MDW: To me, the journey is dangerous – with each step leading the trader closer to ruin. I do not expect this trader to survive very long]

Thanks.

Tristan,

The big issue for me is that you actively seek ways to ‘finance’ trades. That is a slippery slope that leads to taking far too much risk. If a position is not good enough to own on its own, then it does not belong in the portfolio. It does not have any ‘need’ to be financed.

How does financing the position make it any better to own? Portfolios should be managed by risk and not by how much cash can be collected to finance other positions.

Sure, some trades provide cash that can be used to meet margin requirements of other trades. But making those trades just to generate cash is not smart.

I understand your thinking: If a trader can finance his trades by making other trades that he truly wants as part of the portfolio, that’s a good thing. It keeps the account stocked with cash and eliminates the need to borrow money from the broker.

Look at it from a simplistic point of view. The trader has some positions He seeks to finance them by opening more positions, each of which comes with a net positive cash flow. In other words, the trader sells option premium. Each of those trades involves risk.

It takes a very disciplined trader to recognize when enough premium has been sold. It’s important to prevent over-selling. Once the idea of selling more options to finance other option positions takes hold, it is almost impossible to stop. It will appear to be free money – until the account blows up in one devastating moment.

950
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Trading options using market orders

Mark,

I learned something interesting today when taking a loss on a paper-traded position. It was a debit put spread in which the underlying never quite moved into profitable territory and, it being the eve of expiration, I submitted an order to close the position at market open on expiration Friday. (I don’t have time during the day to adjust my positions.)

There was considerable wiggle room in today’s closing bid/ask spread, and I wondered where I should set my limit order to close. Then I realized that, if I really need to get out of this position tomorrow, I probably don’t have the luxury of setting a limit order! So I decided to submit a market order instead.

This was a situation that I really hadn’t foreseen. Just as a trader shouldn’t feel compelled to hold a profitable position until expiration, he/she should be careful about waiting too long before closing a losing position. It would probably have been worth it to give up hope a day earlier and have more flexibility when exiting the trade. I definitely need to put more thought into my trading plan!

Cheers,
RD

***

When trading options there are some things that must never be done – unless you truly prefer to lose money. At the top of the list is to never (under no circumstances) enter a market order at the opening of trading. Note: If you have a margin call and your broker enters that market order for you, there is nothing you can do – except to plead for five minutes to make the trade on your own.

A market order at the opening is a plea

“Please take as much money from me as is legally possible. And if it’s a spread order, please do that twice. In fact, if I am selling a credit spread, please make me pay a cash debit to exit. If it’s a debit spread, please, please make me pay more than the maximum value of the spread to get out of this trade. Thank you.”

If you have a job where you cannot take a five minute break – fifteen minutes after the market opens – that is truly a difficult situation. However, it is just one more reason not to carry risky positions.

There is another lesson in this scenario, and your comment makes it clear that you either don’t see it – or don’t agree:

It doesn’t matter whether it’s a winning position or a losing position. Your entry price was long ago and is no longer relevant. You must concentrate on the current price of the spread, market conditions, and risk vs. reward. You should be able to determine whether holding this position is a good or poor idea, and it has nothing to do with its status as a winner/loser. When it’s time to exit, exit.

One more point: Execution prices in paper-trading accounts tend to be removed from reality. It’s still worthwhile to practice the trades and risk management, but profit/loss is not going to be realistic.

934
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Trading Traps for the Unwary II

Continuing yesterday’s horror stories, Tristan submitted another:

Something doesn’t seem right about this. I was short the 115-116 call spread in SPY 55 times during March expiration. I was assigned on the 115 call (the short part of my spread) on Thursday after the close (found out Friday morning). This resulted in being short 5,500 shares on Friday morning versus my long 55 116 calls. On Saturday, I was debited from my account a significant charge because I was short the shares when SPY went ex-dividend on that Friday.

Am I responsible for the entire dividend payment for that quarter because I was short the stock on that one day of ex? Seems like stealing. I feel like if I had bought the stock that day, there is no way I would have gotten credit for an entire quarter of a dividend payment. Anyone know how this works?

***

“Anyone know how this works?” This is the stuff that drives me nuts. If you don’t know how it works, why are you trading a product where it is essential that you understand how it works?

Dividends are paid on specified dates. Whoever is short on that ex-dividend date pays the dividend. Whoever owns the shares collects. Very simple, very efficient and it has always been this way. It’s also fair and reasonable – for owners of the shares. When the stock (or ETF) pays a dividend, the stock price declines by that amount. Gain the dividend, lose in the share price. No one gains or loses.

Alas, it’s not so simple for option owners. When you own an ITM call option that should be exercised to collect the dividend – WARNING: NOT ALL ITM OPTIONS SHOULD BE EXERCISED FOR THE DIVIDEND – failure to exercise results in a real monetary loss. The trader who submitted the question above did not know about the dividend, did not know he should have exercised his calls, and donated his money to some lucky trader who had been short those SPY 116 calls.

To reply to the comment: You are correct. If you bought shares that day (Friday) you would NOT get any of the dividend. You would be too late by one day.

I do agree with the lamenter’s opening thought. There is something not ‘right’ about this situation. What’s wrong is that you should not yet be trading options because your education is far too incomplete.

More Questions from Tristan

For instance, what to do if long puts are automatically assigned upon expiration

If you know in advance that you cannot meet the margin requirement, then do not allow yourself to be assigned at expiration. BUY THEM BACK before expiration. There is no solution that’s any easier. If you are not short the options, then you cannot be assigned an exercise notice.

or if short legs are assigned in spreads

There is almost never any reason to be assigned earlier than expiration (other than exercising a call option to collect the dividend). However, this is a recurring problem for SPY options. It ALWAYS goes ex-dividend on the third Friday of the month. Not knowing that – in advance – is just a huge mistake. If you fear being assigned on any position, then the answer is very simple (Honest. This is a deadly serious situation) Answer: Get out of the trade. Do not hold to expiration. Ask yourself why would you decide to hold to the bitter end? It is so unnecessary. For goodness sake, get out when you may be assigned and especially when you cannot meet the margin call.

If you are assigned on one leg of a spread, and if margin is not a problem, keep the position. Someone handed you a gift, and if the stock makes a big move (down if you were assigned on a call option or up if you were assigned on a put option) then you will score a nice big payday. It’s unlikely, but it has happened before and will happen again.

However, if you are unable to hold the trade and must liquidate, do not decide to exercise your long option to get out of the position – unless this option has zero time premium. It is more efficient to buy back the short stock and sell your long calls [Or sell your long stock and sell your long puts].

as well as simpler topics such as bid/ask spreads, order types, conditional orders , orders I should place in advance . in case I temporarily go into a coma through expiration, the Pattern Day Trader classification, the same-day substitution rule, Regulation T, etc.

There is a lot of stuff on your list. The truth is that most people have no need to understand most items on the list. That raises the question that concerns you: Why are people allowed to trade when they don’t understand the rules? And how do you know what it that you must know when there is no one to provide a list.

The answer to the first question is easy. They are allowed to trade because it is profitable for the brokers. Nothing else matters.

There’s not much that the average trader can do about the items on your list. If he/she becomes a pattern day trader (not a common situation), that’s when he/she will learn about those trading limitations.

Most beginners have no need for conditional orders and have plenty of time to learn how to use them.

However, bid/ask spreads and limit orders are essential items. I assume that anyone who teaches options classes or writes books for beginners includes that information. Traders who jump right in with no education may have some painful experiences when entering market orders. Not everyone can be protected. Would you open an account and enter orders with no advance study or preparation? Of course not and there is no protection for those who do.

You have one advantage. You are aware that dangers exist, and although you may not ask every question, you will be frightened enough to ask questions about any situation that occurs to you. That may not be enough – but you would have to be very unlucky to not have discovered what you need to know when you aware that you don’t know what it is that you don’t know.

Some answers

Don’t pay the offer; don’t sell the bid.

Never never never use a market order. Limit orders only.

There is no need for fancy order types. Limit orders and stops (I don’t like stops for option traders) should be sufficient.

Buy back shorts when they get very cheap – just in case you do temporarily go into a coma through expiration.

The Pattern Day Trader classification is not a concern, unless you day trade. And if you do, you will soon learn the limits.

You can get much of this information from your broker. But get it in writing. The people in customer service may be as bad as your correspondent found them to be (yesterday)

The CBOE stories scare the living daylights out of me — I wonder what these traders were supposed to have read to understand/avoid those problems in the first place. It is not asking too much to know when a stock/ETF you are trading goes ex-dividend.

It really seems like trading was designed for people who have a Series 7 broker’s license and know all these nuances.

I understand how you feel. The bottom line is that people are trading – and they intentionally did not bother to learn the rules. They make bad assumptions and get stuck with the bill. When you sell a call option, you must know that the owner is allowed to exercise at any time prior to expiration. It seems to be a natural question to ask – why would anyone exercise early? That’s when the trader would learn bout dividends.

You may be frightened, but it seems to me that you are taking care to learn about lurking dangers.

928

No one is forced to trade. Information is available to everyone.

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Trading traps for the unwary

Hi Mark,

I’ve read a few books on options, including one of your books, The Short Book on Options, and I’ve written a few cash-secured puts and covered calls.

Recently, I’ve read of a few cases of new traders blowing up their account due to practical details of the mechanics of trading (described below) and I was wondering if you would recommend any books, education, etc. on these mechanics. For instance, what to do if long puts are automatically assigned upon expiration, or if short legs are assigned in spreads, as well as simpler topics such as bid/ask spreads, order types, conditional orders, orders I should place in advance in case I temporarily go into a coma through expiration, the Pattern Day Trader classification, the same-day substitution rule, Regulation T, etc.

Basically, I’m somewhat shocked that one can even get access to a brokerage account without knowing Regulation T, PDT [Pattern day trader], etc. The stories below scare the living daylights out of me — I wonder what these traders were supposed to have read to understand/avoid those problem in the first place. It really seems like trading was designed for people who have a Series 7 broker’s license and know all these nuances.

Thanks,

Tristan

***

Tristan,

Thank you. These are very important situations, and a thorough discussion can help many traders avoid a nasty situation. And the truth is that these situations arise because we seldom know what we don’t know. We don’t know what questions must be asked, nor are we aware of potential problems. No one warns us.

However, some situations are 100% the fault of the trader. We are responsible for knowing what an option is before trading. We are responsible for understanding risk before we sell naked options. However, we just have no way of knowing when something we do has repercussions that are far from obvious. I don’t blame you for being frightened.

No books necessary

Here is all the education required for the situations described (I am not belittling you, or the poor folks who were hurt – but the truth is that far too many people trade options without following this advice). And I’ve never seen any books on these topics.

1. Know what you are trading. Never take a position if you do not have 100% confidence that you know the rules of trading options.

2. Never trade any options without knowing whether the stock pays a dividend, how much it is, and when it goes ex-dividend.

3. Know the difference between American and European style options.

***

I’m afraid my trade was fairly simple as I used options quite sparingly over the past few years, and have apparently never known the real hidden danger of options. I just bought straight puts.

On March 20th, I was having a pretty good day and thought that I would take a long shot on CME falling. I put in an order for 100 puts strike 230 at .10 and they filled for $1,000. (Right not the obligation.) In the last seconds of the day the shares plunged and ended at 228.62 putting me in the money $1.38/share…but with no time to sell.

I’d never had this happen before. I looked it up and read the statement please have sufficient liquidity or shares in your account. I had neither, so I called the broker to see how I could get the difference. The first lady said they would auto-exercise. I asked if I would need $2.3 M in the account and would I receive the difference (like an index option) [MDW: He is referring to European style options where the option owner gets the intrinsic value in cash – with no shares changing hands] and she responded they would auto exercise after talking with her manager.

I was unsure, so called back. The gentlemen said he thought I did need the $2.3M or the shares, and they wouldn’t extend it on an account with $32K in it (Sensible enough) but was not sure. He suggested I wait until Monday and call the options desk.

On Monday, the stock gapped up pre-market. My account sold at 230 and bought back at 235-236, losing all my money and then some. I guess this is normal. My question is, what are the limits of margin. If $1K got me $2.3MM, would $10K get me $23MM? Is there a limit? From the archives of Pete Stolcers:

***

Tristan, this situation wakes me shudder on so many different levels that I don’t know where to begin.

What makes this an especially horrible story is that two people at the brokerage firm – and one has a managerial position – told the customer that they would auto-exercise the options and that he should wait until Monday.

Anyone with a working brain would have told the customer to do one of to things:

  • Find a broker-dealer who was open for business and try to buy up to 10,000 shares under 230. I recognize that the customer did not have the buying power to cover the cost, but owning puts than can be exercised should make the margin requirement for that long put/long stock close to zero.
  • But an even better solution – in fact, the solution so obvious that these two people should lose their jobs over not telling the client about it – was to simply fill out a ‘DO NOT EXERCISE’ form. Sure, that would appear to be throwing $13,800 into the trash, but if questioned by any investigator – the truth (inability to buy the shares) should justify the non exercise decision. That step would remove 100% of the risk and kill the problem

But telling the customer to wait until Monday? Can you imagine the anxiety of that customer? When Monday morning arrived he would still have the same problem – dealing with more people who could not help.

Those calls did not have to be exercised and the broker should be held accountable. in the real world, the shares had to be bought – no matter the price.

I’ll save Tristan’s other example for another day.

927
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ITM Calls as a Stock Substitute

I found this series of questions to be quite valuable. Here we have a relatively new options trader who finds an excellent method for reducing risk, but who gets caught up in a mistake that makes him question his methods.

Mark,

I’ve been using DITM options for swing trades, while utilizing the leverage to potentially increase the return of buying stock outright.

Plus much less downside risk, unless you decide to buy extra options with the cash not used to buy stock. To be clear, I’m hoping that you do not decide to buy 10 calls, paying $8 each, Instead of $100 shares at $80/share. That’s a very bad idea. You must determine your correct position size by the number of shares you would have bought, and buy only one call for each of those 100 shares. Careful position sizing is essential to risk management.

I usually pick the first strike showing a 1.00 delta. My question is whether this is actually a good risk to return strategy based on the changing delta.

You adopted an excellent strategy, but your focus seems to be misguided.

100 delta options are too far in the money – unless it’s expiration week. The major benefit of using this trading method (buying calls instead of stocks) is to gain a large amount of downside protection. As you know, a market tumble can be quite costly for stockholders.

If you chose ‘high delta’ options instead of 100 delta options, you would gain that protection at a very modest cost. I urge you to consider the idea of paying a few dimes over parity for a call option that has a 75-85 delta instead of paying closer to parity for that 100 delta option. This is a personal decision and if you refuse to pay that time premium for protection, so be it.

Example

With the stock trading at $76, don’t buy the 65 calls (price = $11.20). Instead, buy the 70 calls (price $6.50). That extra $30 reduces the potential loss. Consider it to be an insurance policy.

Next, I understand neither your reference to changing delta nor “risk to return strategy”.

1) The risk to return is outstanding. You cut the dollars at risk from a gigantic number (when owning stock) to a much smaller number (by owning a call option). Surely you understand that.

2) Changing delta? If you are unfortunate enough to see the stock decline by enough for the option delta to become < 100, that's GOOD for you. You seem to believe it's costing money. All it means is that you would lose LESS money per point of decline that you would lose if owning stock. I have one question for you: If you are a swing trader, why would be holding a long position in this stock when it declines by so much? That is not how swing traders operate. They are quick to cut losses. Remember, until the stock falls enough to cut delta, you lose $100 per point. 'Changing delta' doesn't mean much in your scenario because 100 delta options don't change delta very quickly.

Say I pay $10 for a call with a 1.00 delta, and based on this, expect about a 10% move in option price for a $1 stock move (give or take some). The stocks drops. At this point the option price and delta will also drop,
which could very easily cause the percentage option loss per dollar to go up based on higher volatility.
.

You are off on several wrong paths here, and that’s the reason for posting this discussion. This is a good learning opportunity for rookie option traders:

a) You should expect the ‘give or take’ to be essentially zero for a 100 delta option

b) You are thinking in percentages, and that is confusing you. As a swing trader, concentrate on what you are doing. You are buying (or selling short) stocks, looking to make a few dollars per share. Using call options changes nothing in your basic plan – except that it reduces risk. Concentrate on dollars and forget those percentages.

c) You do NOT KNOW that the option delta will be less than 100 when the stock declines by one point. You did say these are deep in the money options.

d) If there is a change in implied volatility, you WILL NEVER lose ore than $1 per point in the price of an option when the stock declines. Why? You own the option. You own the vega. You BENEFIT when the implied volatility increases. Thus, any losses would be reduce by that change in volatility. Couple that with your anticipation that the delta becomes less than 100 and you benefit again by losing less than $100 per point decline (in the sock price).

Here’s where you miss the big picture: If the volatility increase is large enough – due to a general market scare – you can MAKE money on the decline when oping calls! Did you know that? Get out your option calculator and see what happens to the value of a call with a 70 strike price when implied volatility goes from 30 to 60 and the stock declines from 75 to 70. Assume options have 30 days before they expire. [Your calls would lose less than $1 in value. If they were longer-term options, they would increase in value]

Should the stock move higher, the volatility may decrease and the delta is maxed out at 1.00. Thus, my option price increases, thereby lowering my percentage gain.

No. Delta may be maxed at 100, but so is the delta of the stock. The long call and the long stock move in tandem. The percentage return is totally unimportant – and in fact, it does snot change. You paid $10, so every one point gain is another 10% return on your investment. Plus, your return is far better than that of the stockholder. I’ll say it again. Forget those percentages.

So I’m wondering if this approach actually causes a disadvantage as the reward potential for say a $2 increase may be lower than the risk potential of a $2 drop because the percentage gain decreases for every dollar going up while increasing for every dollar going down. So I may make 18% on a $2 upside but in exchange for a 30% drop for a $2 drop … again give or take.

No. You illustrated why your idea is good. The bad things you found in the strategy are imaginary. They are contrary to fact. You earn as much on the upside (you may earn a little less if you take my advice to buy options with a small amount of time premium). To compensate, you have an excellent chance to lose less than $1 per one point drop in the stock price.

Sit down. Think about this carefully.

One additional point: These DITM calls don’t do the job for stocks that pay decent dividends because you may have to exercsie for the dividend to prevent losing money.

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Lessons for the Options Beginner

The following short video was prepared to explain a simple options concept:

Why option owners elect NOT to exercise an option prior to expiration

This is the type of ‘extra’; that occasionally will be available at the new (launching April 1, 2011) Options for Rookies Premium website.

Exercising a Call Option: Don’t Do It

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Understanding Option Basics

In this post I painstakingly explain one of the most basic option basics to a reader who is having trouble understanding that concept.

Mark,

Here is my follow-up question (original Q &A are here):

Jeff,
I am here to help you understand how options work, but am at a loss as to where to begin. I’ll explain in the simplest possible language. I am not talking down to you. I am trying to get you to move past a mental block.

FACTS

1) Any time that an option is in the money (ITM) at expiration, expect that its owner will exercise. Even when it’s ITM by one penny.

2)The option owner must fill out and submit a DO NOT EXERCISE form to prevent the Options Clearing Corporation from exercising ITM options

Many beginners do not know they have the choice to not exercise

Many beginners forget they own the options or forget that expiration has arrived. As a result, they become owners of stock that they do not want, and cannot afford to purchase

Many beginners make mistakes. Let’s minimize yours.

***

Call strike price + premium paid = break-even

I’ve placed your equation in bold. It is of vital importance that you understand one thing about that equation:

    This equation, all by itself, is the cause of your problems

. Forget it. It has no relevance on whether anyone exercises an option. Your formula is fine for keeping records, after the trade is closed. It is unimportant now. More than that. It is currently causing confusion and limits your ability to recognize the truth.

Using such a formula, does it follow that when the stock price is less than the break-even, then the call would not be exercised? For example, if at expiration the stock was $15.05 and one had purchased the $15 strike for a $0.10 premium, it seems one would not exercise the option.

No, it does not follow. If you ignored your break-even equation, you would never ask this question. You believe the owner of your call option would throw away $5, just because it represents a loss! Look at it from the perspective of someone who owns 100 calls. They are worth $500 to the trader.

You are saying that it ‘seems right’ for trader would throw away $500 because he paid $1,000 for that investment. No one in his right mind would do that.

To clarify: Have you ever sold stock at a loss? Did you consider telling your broker to take the shares out of your account and to give them to some randomly chosen person? Instead of taking current value for your stock, you could have chosen to make them worthless to yourself. Surely you know not to do that. When taking a loss, you recover some money. Your money. This situation is no different.

You must not toss cash in the trash just because the trade is at less than break-even.

If you lost a $10 bill and the next day found a $5 bill, would you refuse to pick it up because your loss was a larger sum? This is exactly the same. You must understand this principle. I don’t know how to make it more clear. Those options are worth $5 apiece and only an idiot would elect not to collect cash for them. [Exercise is a different decision and trust me when I tell you that selling is better for you.] Whoever ends up holding those options will exercise at expiration.

There is a tiny [my guess is less than one chance in 10 million] that an option ITM by five cents would not be exercised by its owner. But, it remains a possibility. People do make mistakes.

Yet I have read that options will be exercised if the stock price exceeds the strike price at expiration [MDW: this is only true for calls; for puts the stock must be below the strike], which it does in my example. It makes me wonder if there are other factors being considered by the call buyer. One rule, which I assume is adopted by the industry, is that all options in the money at expiration by $0.05 or more are automatically exercised, unless otherwise directed. What other factors could cause calls to be exercised below the break-even detailed above?

Yes, automatically exercised. The OCC does not care about break-even. Nor should you. Today the number is ITM by $0.01, not $0.05.

You want to know what other factors would make someone exercise when that exercise (or sale) results in a loss. Here’s the answer: MONEY.

When you invest or trade, it is inevitable that you will have losses. When you have a loss, you do not have to lose every penny. The trader is allowed to sell (or exercise) to recover some money. You probably understand that process. However, when expiration comes into the picture, you ignore what you know because you think about that break-even nonsense. When you fail to exercise (or sell), you allow the option to expire WORTHLESS. Why would you take zero for an option that you can sell for $0.05? Answer that one question (correctly) and you will understand.

How can the original cost matter? That’s your hang-up. That break-even is bothering you. Today, right now, you have a choice. Take $5 or take zero. It’s as simple as that.

Perhaps my question was misunderstood. I discussed selling the call rather than at what stock price a call owner will exercise. I understand and agree with you that it is better to sell your call for any amount rather than let it expire. I also understand what you mean by saying the premium paid is meaningless. Yes, if your plan was to sell the call and not exercise it then the premium paid is meaningless in terms of deciding whether you are going to sell the call or let it expire.[MDW: If you understand that, then why are you asking?]

(However, the premium is not meaningless if you want to determine if your trading strategy is successful as it represents part of your investment.)

I did not misunderstand. The premium is meaningless, as you admit.

You continue to look at useless items. You think record keeping and evaluating your strategy play a role in this discussion. They play no role when it’s time to make a trade decision. They are used after the fact to see how well you did. [If you disagree, and I have no doubt that you do, that discussion is for another time]

Also, I think you misunderstood my example when I said the stock price was $15.05 and I had a call with a $15 strike for which I paid $0.10. This was interpreted as the stock was trading at $15.10. Perhaps the price relationships I used in my example would not exist in the market. I apologize if I improperly set my example.

When you buy the call at ten cents, and eventually exercise, then you buy the stock at the strike price ($15) per share, but your cost basis is $15.10. You did not improperly set your example. Nor did I misunderstand.

Even so, I am encouraged by how you ended your response: “In this scenario you should almost never want to exercise”. This indicates to me that the risk of owning the stock, plus the additional investment required, must produce a greater return than displayed in the example before exercising the call becomes likely (at least for you).

No, not for me. For everyone. You made an investment. You sought a certain return. You did not earn that return. so what? Today is decision time: You take your $5 or you don’t. ‘Return’ no longer applies.

You are confused because you are looking at too many variables

You are concerned with break-even. You are worried about whether your strategy is working. You think about producing ‘a greater return.’ NONE of that matters at the time when the call owner decides what to do with the options: sell, exercise, discard. You either take the $5 or you don’t. It’s that simple. There is nothing else to consider. The fact that you have irrelevant items on your mind is the reason this is a problem.

I’m still left not knowing at what stock price / strike price combination calls are usually exercised. [MDW: Of course you know. When the stock is at least one penny in the money options are exercised.] I suppose as a buyer it would be when the stock price is greater than the strike price plus the premium. [MDW: NO] As a covered call seller it probably would be best to assume it would be when the stock price exceeds the strike price.[MDW: YES] Although this is not technically correct since a call’s price must be greater than zero to be sold, it’s probably good enough.

Calls are always exercised when they are in the money at expiration. Period.

There may be the occasional individual investor who correctly (for his/her situation) decides that exercising is too expensive because of commissions (and there were no bids when he/she tried to sell the call), but in general, all ITM options are exercised. That is all you or anyone needs to know.

Over the years, if (and only if) you can overcome your mental block, you may not be assigned a couple of times when the option is ITM by a penny or two. Just don’t expect it to happen.

I appreciate your efforts to help me with my question. I’m sure when my covered calls expire next week I will have an even better understanding that can only come from experience. Thanks again.

You are welcome. However, your entire conversation was from the point of view of the call owner. As the call seller you will learn zero about the mindset of the call owner. ZERO.

You must open your mind, throw out your misconceptions, and the truth will be right there in front of you. This is not difficult. This is the easy part. If you cannot understand this, there is no chance you can ever learn to use options effectively.

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