Q & A. Lightning Round

What is the difference between nonstandard and standard options?

GW

A non-standard option is one that exists after a corporate action – usually a merger, takeover, spin-off.

The old options must be adjusted to reflect the changes, and that means contract becomes non-standard to reflect the conditions of the 'action.'  Anyone who exercises a non-standard call option receives (upon paying the original strike price) the same 'package' that the holder of 100 shares was entitled to receive because of the action. 

[And a put seller has the right to sell the same package, and collect the original strike price]

Example: If a stock (XXX) spins off a subsidiary (SUB) such that all XXX shareholders are entitled to receive 0.05 shares of the new company for each one share owned, then the existing call options are adjusted to reflect that spin-off. Upon exercise of the old (now, the non-standard) option, the exerciser buys or sells 100 shares of XXX PLUS 5 shares of SUB at the original contract strike price.

New, standard options are issued (often one day later). These are 'normal' options and the deliverable is 100 shares of XXX and none of the subsidiary.

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I am new to options trading and have a question on the fundamental difference between buying a put and selling a call. As I understand it, they are both bearish. Why would you sell a call vs. buy a put? Is it simply because when you sell an option you get upfront money?

Thanks,
AP

The difference is huge. When you buy an option, you have rights. When you sell an option, you accept obligations. That's why option sellers are paid – to accept those obligations.

On an elementary basis, they are similar in that each represents a short position on the stock. Yes, each is a play that the stock will move lower. But that's where the similarity ends.

When you sell a call option, you collect the premium (cash) up front. That's good. But if the stock heads higher, your losses are potentially unlimited. When, for example, you sell someone the right to buy stock @ $40 per share, the stock may move to 50 or 60 or 200. At some point you will be forced to either buy back that option or sell 100 shares at $40 per share.  Thus, you may have a gigantic loss.

When you buy a put option, you pay cash.  But in return for that cash, you have the right to force someone to buy stock and pay the strike price per share. If the stock tumbles, you can make a lot of money.  If the stock rallies, you lose no more than the cost of the option.

Many times, the option buyer doesn't see the stock move as expected and the cash paid to buy the option is lost. That's why buying options is so difficult. To profit, you must pick the correct direction for the stock. Not only that, but the stock price change must occur fairly quickly – before the option expires – and the move must be large enough to offset the price paid for the option. All in all, buying options is a difficult undertaking.

As an aside, selling a call option when naked – that means you do not already own enough stock to deliver when the call option is exercised by its owner – is not allowed by many brokerage firms. They consider that strategy far too risky for option traders. Especially rookies. I agree with that policy.

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If you put on a credit spread, eg. buy an ABC July $570 call for $1.60, and sell an ABC July $560 call for $2.63, and both expire worthless, how do you calculate your return in percentage terms (what number goes into the denominator)?

Thanks…..Deb

As you know your return on investment depends on the amount invested.  When trading credit spreads, there is no 'investment' per se. But, you have money at risk – and that amount is your investment because for most traders, that is the margin requirement (when using Reg T margin rules).

Thus, return = profit / money at risk.

In your example, return = $103 / $897

You sold a 10-point spread, and the maximum value that spread can reach is 10 points, or $1,000. You collected $103 for the spread – making your maximum loss (and margin requirement) $897.

To provide a more accurate number, include commissions in the calculation. Thus the numerator is $103, less commissions. You can ignore the cost of closing the spread right now, but be aware of the commissions involved because you may want to exit the trade early, and much of that $103 can disappear if your commissions are too high.

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2 Responses to Q & A. Lightning Round

  1. greg 09/04/2009 at 2:20 PM #

    Appreciate your recent blogs – very helpful for rookies and am enjoying your books. Wish I had known about options a few years back….. my son, a CPA and MBA got me onto options. Sure potentially beats just holding stocks. I like your conservative risk based approached after years of having a 401K with limited fund choices.

  2. Mark Wolfinger 09/04/2009 at 2:28 PM #

    Greg,
    Very intelligent son you have! Give him my regards.
    Feel free to send along your own questions.