3 Possible Outcomes in Options (Part 2)

11/30/2011 7:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

This two-part series concludes with a review of the three scenarios that can result from short option positions, including closing the position prior to expiry, or realizing one of two “inactivity outcomes.”

Read Part 1 of this two-part lesson here.

Short Options Position

In the case of selling something, the sale precedes the purchase. Chronologically, we first sell to open (STO) and then we buy to close (BTC); 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.

Chart1

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 profit or loss; I am 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 expiry and observing the inactivity outcomes. Again, there could be two inactivity outcomes, one desired and the other undesired.

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 out-of-the-money (OTM) options that have some extrinsic value, or time value, left in them.)

The third and least-desirable outcome for our sold option is the exact opposite of being out of the money (OTM). In the case of our sold option ending up in the money (ITM) prior to the expiry, we must either buy back our obligation no matter what the current price is or suffer the consequence 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 philosophy “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 two-part article series, 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 also 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 to learning options. 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, instructor, Online Trading Academy

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