Getting Back to Basics in Options (Part 2)
11/18/2009 12:01 am EST
Short Options Position
In cases of selling something, the sale precedes the purchase. Chronologically, we first STO (sell to open) and then we BTC (buy to close); or we sell high with the aim to buy back at the lower price. Many new traders who get exposed to options could not get over this concept that indeed it is possible to sell something before you even own it.
If there is enough money in our account to perform such transactions of covering the expense of selling something, then the broker would allow us to proceed with our short transaction. However, in case we do not have enough funds in our account to meet the broker requirements, the short transactions will be rejected.
Hence, the outcome of the first scenario is to close our open position by selecting BTC (buy to close). Again, I am leaving out of this discussion the whole concept of for profit or a loss. I am instead focusing only on us taking this action of BTC prior to the expiry.
The second outcome could involve leaving the position open or unclosed until the expiry and observing the inactivity outcomes. Again, there could be two outcomes: One desired one, and the other, undesired one. When we sell something, the only way to achieve the maximum profit is by letting our sold option expire completely worthless, meaning the option premium goes down to zero and our option expires worthless.
(Hopefully, when we sold the option, there was a juicy premium in it, making the selling transaction worthwhile. I advocate the selling of OTM (out-of-the-money) options that have some extrinsic, or time, value left in them.)
The third and least desirable outcome for our sold option is the exact opposite of being OTM. In the case of our sold option ending up ITM (in the money) prior to the expiry, we must either buy back our obligation no matter what the current price is, or suffer the consequences of our inaction.
Option trading always requires monitoring our open positions and acting according to our initial trading plan. At Online Trading Academy, we always teach the concept of “Plan the Trade and Trade the Plan.” A failure to plan a trade prior to entry is indeed planning to fail.
In conclusion, in this article, I have pointed out that without a deep understanding of option fundamentals, an option trader could not break to the higher level of advanced option trading. I have laid out some of the basics that are often overlooked by many. It is in the clear understanding of the fundamental intricacies of options that the secret of solid option foundation lays.
There is no shortcut in learning options trading. An in-depth comprehension of basic concepts must precede the more advanced ones. Good trading, and make sure to have a clear plan prior to getting into any option position.
By Josip Causic of Online Trading Academy