A Summer Review of Options Trading Basics

07/10/2014 8:00 am EST

Focus: OPTIONS

Steve Smith

Reporter (Options Columnist), Minyanville

Not only is it invaluable to review these options basics during the slow summer months, but to also remember them throughout the entire year, says Steve Smith of Minyanville.com.

Options are a valuable investment tool that can both boost returns and reduce risk—but only when used properly.

That’s why it’s time to bone up on some basic options trading principles.

I'll tee up a few topics and also offer some reading suggestions for those who want to delve deeper and don't mind being spotted on the beach with an options book.

Operations Manual

Before trading, understand the basic rules and guidelines that govern options' behavior.

For starters, make sure you know the contract specifications for the product you are trading.

Margin requirements (pay special attention to leverage), the exercise and settlement procedures, and what strikes and expirations are currently listed are all important to know.

For example, you should be aware that index options, such as those on the S&P 500 (SPX), can only be exercised on expiration day and are cash settled; also note that SPX options actually cease trading on the third Thursday of the month, a day earlier than equity options, though they officially expire on the third Saturday.

By contrast, equity options, including those on ETFs like the SPDR S&P 500 ETF Trust (SPY), can be exercised at any time during the life of the contract.

This is especially important when trading options on stocks that pay dividends.

Dealing in Dividends

Knowing the basic rules by which the various vehicles operate will help you avoid surprises such as an early assignment on an in-the-money call.

If you own in-the-money calls on Exxon (XOM), for example, make sure you know when the ex-dividend date occurs—you will need to exercise your calls if you want to own the stock and qualify for the payment. Likewise, if you are short an in-the-money call on a dividend-paying stock, be prepared to be assigned and short the actual shares the day before it goes ex-dividend.

Most ETFs pay dividends. Some, like the Spyders, pay out on a quarterly basis. For some reason, the ex-dividend date often falls on the Thursday prior to a quarterly expiration. Many people fail to exercise in-the-money calls and lose out on the dividend, while others are unwittingly assigned stock and are forced to pay.

Others, like the SPDR Dow Jones Industrial Average ETF (DIA) make monthly distributions.

Jargon Slashing

Option traders love jargon. The lingo serves several purposes: It connotes a high level of knowledge and expertise and accurately conveys complex concepts in a concise manner.

And sometimes it's just fun to say things like "I'm long vol up the ying-yang and bleeding theta," which basically means that one is suffering from time decay.

Scalping gamma is a fancy way of saying "I'm trying to buy low volatility and sell higher volatility as the price of the underlying stock moves back and forth within a trading range."

The downside of lingo is that it's sometimes used to fake true expertise, perhaps to get the upper hand in a conversation or negotiation. This can be very off-putting to a layperson.

While it's not important to know all the jargon, it is imperative to understand the basics.

By Steve Smith, Contributor, Minyanville.com

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