(11/17/09) Getting Back to Basics in Options (Part 1)

Education is usually the first thing to get cut in times of financial difficulties by the local and state governments. Many times, the label "Back to the Basics" is being used as a justification for the sole academic focus on math, reading, and writing at the expense of fine arts. However, in our case of strictly options education, there are no cuts or short cuts.

The types of questions I have been receiving over the past month or so have been an indication that many of my readers are not at the level where advanced option strategies (such as condor spreads, iron condors, and multiple simultaneous option trades) could be easily comprehended.

Hence, for the time being, I will go "Back to the Basics" to ensure that some of the fundamental concepts of options are clear to the majority of our community. (It is my belief that option trading could be mastered only if one has a very solid foundation of what options can do and how they can be used.)

Complete Awareness

An options trader must have a complete awareness of all possible outcomes when entering an option position, which could be beneficial as well as hurtful. By our human nature, we tend to be optimistic, yet as option traders, we need to find the middle ground between our optimism and skepticism.

Hence, when entering an open position with the order stating that we are ready to either BTO (buy to open) or STO (sell to open), we must be grounded in reality. The consequences of our mouse-clicking actions could go against us as well as in our favor. In many case, the former is the most likely occurrence.

We can quantify the outcomes of our BTO actions in three possible scenarios. Figure 1 presents the outcome visually:

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BTO Outcomes

The first one would be closing our open position with an opposite closing transaction stating STC (sell to close). For the sake of this discussion, whether we closed it for a profit, loss, or just at BEP (break even point) is irrelevant. Therefore, on Figure 1 for "Outcome," I have placed the word "Depends" because more specific data is needed to make any generalization.

The second possibility would be to take no action whatsoever and wait for one of the two possible outcomes at the expiry. At the expiration, our long position is either OTM (out of the money) or ITM (in the money). In case of our long call or put being OTM at the expiry, we have achieved our maximum loss of the premium paid at the entry, plus our initial purchase commission.

In the case of ending up ITM, even by a single penny, according to the new rules and regulations of the OCC (Option Clearing Corporation), our option would get exercised. As much as we, as option traders, could disagree with this recent enforcement of exercising of any ITM options even by a penny, there is no possibility of turning back the clock to the time when the automatic closure of our positions was done only on the 25-cent ITM options by our brokerages.

Those days are gone. The logic of closing a long position that was ITM by the 25 cents by a broker was commission-based. In those days, on the Friday morning of expiry, the brokers used to send out an e-mail to us stating that if the options that are ITM by 25 cents aren't closed by 11:00 am eastern standard time, it will be up to their discretion to close it at anytime between 11 am and the close at 4 pm EST. By the way, 25 cents on a single contact equals 25 dollars, out of which the brokers would pay themselves first, many times charging double commission.

For instance, $9.99 for the ticket, plus 0.75 per contract, as well as an additional $10.00 fee for an "Assisted Trade." Again, the specifics of the commissions vary by the broker, but I want the readers in our community to be aware of all the consequences involved with option trading, especially when selecting inactivity as a part of our option trading strategy.

Nonetheless, it is better if we close our own ITM position than to wait for our broker to take action on it. Inactivity always has a cost. Be aware where your open position is trading during the week of expiry and act according to your original plan, which was supposed to be created at the entry.

Moving on to the possible outcomes of the short option position, or STO (sold to open) position. Once again, Figure 2 highlights three possible scenarios:

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