3 Things You Can Do with an Option

07/14/2014 10:30 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

For the benefit of those new to single options, Mark Wolfinger at OptionsforRookies.com offers an introduction to the three things you can do with an option.

This discussion refers to single options and not to options that are part of a spread position.

Once you own an option, the best strategy for any trader is to establish and follow a trade plan. I'll be offering more information on what should be included in such a plan, but the important point for today is to be certain that every trade plan contains at least these two elements:

  • Profit target. Your plan is to exit the trade when that profit becomes available.

  • Worst case scenario that you are willing to accept. Do not fall into the trap of failing to sell any option position-once you no longer want to own it. Too many dollars are lost when traders hold onto a bad position and hope for a miracle to save them. Hope is not a strategy.

Option Owner's Alternatives

There are only three things that can be done.

  • Sell the option. This should be your primary objective. The ideal situation is for the option price to increase and for you to be able to sell the option and realize the desired profit. However, we don't always achieve our trade objectives so an option owner has to be aware that the passage of time erodes the value of every option. Thus, be prepared to make a frequent (probably daily) decision: Do you want to exit today, accepting a smaller-than-hoped-for profit or perhaps accepting a loss—or do you have a valid reason for preferring to hold longer?

  • Exercise your option. When you take this action, you are doing what the contract allows. You have the right to buy (if you own a call) or sell (if you own a put) 100 shares of the underlying asset (stock) at the strike price. We use the term 'exercise the option' to describe this action, but, in reality, the trader exercises his 'rights' and not his option. There is seldom a good reason for exercising. There is no good reason for a new option trader to want to own stock because that could result in a significant loss if the stock price really declines. One of the reasons for owning an option instead of stock is to limit downside risk.

  • Allow the option to expire worthless. This is the choice that you hope to avoid. However, option buyers must recognize the simple fact that if they never sell the option and expiration arrives—if the option is out of the money then the option has no value and expires worthless. The option owner's rights expire with the option. The loss, although limited, is 100% of the purchase price. If you bought an appropriate number of options (i.e., traded an appropriate position size) than your risk-management skills should mean that this loss is not too large for you to accept calmly.

Those are the three alternatives when you own an option.

By Mark Wolfinger at OptionsforRookies.com

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