There is no substitute for an education

I recently received an email message from a true options beginner.  He made a trade, did not understand the trade and wrote to ask about it.

This is simply the wrong sequence of events.  It's mandatory to ask the questions first, and if and only if, you understand the answer, then it's okay to make the trade.

This gentleman owns 300 shares of a given stock and wrote three call options at an unbelievably high premium.  The stock is trading near 6 and he wrote three Jan 7.5 2011 calls.  These are nicely out of the money, but he collected a premium of $6.40.

As I am sure most readers are aware, these must be non-standard options.  My correspondent also knew these were non-standard options, but did not know what that means.

Non-standard call options require delivery of something other than 100 shares of stock when the writer is assigned an exercise notice.  Due to a special dividend, the deliverable is 100 shares of stock plus $217 cash.

[ADDENDUM: The truth is that there is another non-standard option with the same strike and expiration.  He may have sold that one – and it requires delivery of $425 plus 20 shares of a different stock, in addition to 100 shares of the underlying.  It can be treacherous out there.]

The sad news is that he sold these calls under parity – for less than their intrinsic value.  There's nothing to be done except to learn a lesson.  He thought he had made a great trade, but decided to ask my advice.  Sadly the advice came too late.

This situation truly saddens me. 

Please learn first, trade later.

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6 Responses to There is no substitute for an education

  1. 5teve 07/14/2010 at 6:58 AM #

    Hi, Mark
    you are right. It is so important to learn first and trade. I’ve made the same mistake. once I sold some covered calls with high call premium, ignored everything else, and the underlying went down more than 50%. there must be a reason why the premium of an option is so high.
    another question: besides high premium, how do you tell if it is an non-standard option? the brokers may tell when you trade?
    thanks

  2. Mark Wolfinger 07/14/2010 at 7:24 AM #

    5teve,
    High premium is one thing. That’s common when news is being announced – especially an FDA announcement about a drug.
    But in this example, the 7.5 call was trading much higher than a 7.00 call option. Because that’s impossible, you know something is wrong.
    in addition, the corresponding put was zero bid. This specific option appears to be 1.50 point ITM and the put is zero bid and $0.15 ask. That’s how you can tell. That’s how you know it’s an impossibility.
    Until the recently the option had a different symbol. That’s no longer true. I’ll try to find out and update this reply.

  3. Aaron 07/14/2010 at 1:13 PM #

    Im still pretty new to this option thing.
    If I sell a call option on a stock at 62.50 and buy another at 67.50 I create a spread. If the stock closes at say 63.00 at expiration, what happens? Will I have to buy the stock and sell it at $62.50 or just lose a certain amount of money per contract?
    Also, when a stock pays a dividend the price falls based on this right? Knowing this ahead of time couldnt someone just buy a put a week or so out and sell when the stock drops at a profit?

  4. Mark Wolfinger 07/14/2010 at 1:52 PM #

    Good questions Aaron,
    1) If the option you sold is in the money at expiration (per your example), there are a few choices.
    Yes, buying the stock at 63 and selling at 62.50 (the strike price) is one of those choices.
    However, it is far easier, and saves commission dollars to buy back the call with the 62.50 strike price. Buying to close the position cancels your short option and cancels your obligation to sell shares at the strike price.
    NOTE: Once you receive a notice that the call has been exercised, it is too late to repurchase that call.
    If the stock rises so far that your long call (67.50) is also in the money, then you don’t have to do anything. You will automatically sell stock at the lower price and repurchase it at the higher price. In other words, the worst has happened and you must pay $500 to close the trade.
    2) No, you do not lose ‘a certain amount of money.’ That is what happens when you trade options that are settled in cash. Stock options settle in shares. All that means is when an exercise occurs, shares change hands. As an aside, the big stock indexes (SPX, RUT, NDX) use options that settle in cash.
    3) When a stock pays a dividend, the norm is for the stock to open the next day – at a price that is lower than the close – by the amount of that dividend.
    If you know that the stock is going to pay a dividend next week, then so does everyone else. The dividend is already included in the price of the put option.
    Example: Stock is 60 and pays a $1 dividend. The Aug 70 put is not trading at $10. It is $11 becasue the put ‘knows’ that the stock will be $1 lower next week.
    Thanks for the questions.

  5. amit 07/14/2010 at 2:53 PM #

    Mark,
    Sorry to be offtopic a bit. But the only way I learn is by putting money on the line, making mistakes and not doing THAT mistake again. Got caught in a squeeze, extricated myself with considerable difficulty. Licking my wounds right now. A few days when you or somebody eles said “Waiting for expiration is so retail” is absolutely right. What shenanigans they play, I gotta hand it to them. Had a sleepless night 2 days running yesterday & day before wondering if I would be assigned. I should have taken the 70% of premium. Chalking this to experience.
    Is this why you dabble in RUT only? I was thinking of dabbling in SPY.
    Thanks

  6. Mark Wolfinger 07/14/2010 at 3:06 PM #

    Amit,
    You are never off topic.
    Detailed reply tomorrow.