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Options University’s Options 101 - Part 4

Filed Under Options 101 

Options 101

Part 4

Short selling works because traders are obligated to return a fixed number of shares and not a fixed dollar amount. In our example, you shorted 100 shares with a value of $7,000. Your obligation is to return 100 shares of IBM and not $7,000 worth of IBM. If you can purchase the shares for less money than you received, you will make a profit.

This is not meant to be a course in shorting stocks but rather a way to understand what the term "short" really means when applied to the stock or options market. Shorting means you receive cash from selling an asset you don’t own and then incur some type of obligation. In the case of shorting stocks, your obligation is that you must buy back the shares at some time.

If you short an option, you have sold something you don’t own. You get cash up front and then incur some type of obligation depending on whether you sold a call or put. If you short a call, you get cash up front and have the obligation to sell shares of stock. If you short a put, you get cash up front and have the obligation to buy shares of stock. The cash is credited to your account immediately and is yours to keep regardless of what happens to the option. That is your compensation for accepting an obligation, much like the premiums you pay to an insurance company.

When you sell (short) an option you will receive cash, which is yours to keep regardless of what happens in the future. 

The following table may help you to visualize the rights-versus-obligations relationships:

 

 

LONG

SHORT

Call

Right to buy stock

Obligation to sell stock

Put

Right to sell stock

Obligation to buy stock

Notice that the long and short positions are taking opposite sides of the transaction. For instance, the long call (call buyer) must be matched with a short call (call seller). The long call has a right while the short call has an obligation. Rights and obligations are opposites. In addition, the long call gets to buy while the short call is required to sell. Buying and selling are also opposites.

For put options, the long put (put buyer) must be matched with a short put (put seller). As with call options, it is the long position that has the right while the short position has the obligation (opposites). The long put, however, has the right to sell while the short put is required to buy (opposites).

This arrangement is required to make the options market work. Both parties (the buyer and seller) cannot have rights. They can neither both buy nor both sell. One side has the right to buy (or the right to sell), while the opposite side has the obligation to complete the transaction.

This arrangement is often a source of confusion for new traders. They wonder how the option market can work if everybody has a right to buy or sell. The answer is that it is only the long position that has the rights. The short position has an obligation. It is important to understand this relationship when going through this book, especially when you get to strategies.

Long options have rights. Short options have obligations. 

Getting Out of a Contract

We just learned that you can get into an option contract by either buying or selling a call or put. But once you’re in the contract, is there a way to get out of it at a later time? The answer is yes. All you have to do is enter a closing transaction (also called a reversing trade). In other words, you can always "escape" from your rights or obligations by simply doing the reverse set of actions that got you into the contract in the first place.

For example, if you are short an option and decide at a later time you don’t want the corresponding obligation, you can get out of it by simply buying the options back. This is much like you do with shares of stock if you are short. However, just because you can get out of the contract doesn’t mean that you can avoid any losses that may have accrued. The price you pay to get out of the contract may be higher and, in some cases, much higher than the price you originally received from selling it – just as when shorting shares of stock. But the point is that you can get out of a short option contract by simply buying it back.

If the idea of buying back a contract sounds confusing, think of the following analogy. You probably have a cell phone are locked into some type of agreement such as a one-year contract. Cell companies do this to prevent people from continually shopping around and jumping to the hot promotion of the month. However, your cell provider will also have some type of "buy back" clause in the contract. That is, if you wish to get out of the agreement, you must pay a fixed amount of money, perhaps $200, and you can escape your remaining obligations. If you pay this fee, the company cannot take you to court later and say that you didn’t fulfill your obligations. The reason is that you bought the contract back – it no longer exists between you and the company. That’s the fee they specified to end all obligations.

This is mathematically the same thing that happens when you buy back a contract in the options market. Although it is not a fee to end the contract, what you’re really doing is going long and short the same contract, thereby eliminating all profits or losses beyond that point. If you’re long the contract and you’re short the same contract, then you’ve effectively ended all obligations.

Likewise, you can get out of long call option by simply doing the reverse; that is, selling the same contract that you own. Because of this possibility, most option traders simply trade the contracts back and forth in the open market rather than using them to buy or sell shares of stock. As we will later see, trading option contracts is a big advantage because they cost a fraction of the stock price.

You can always get out of an option contract at any time by simply entering a reversing trade.

Let’s make sure you understand the concepts of long and short calls and puts by using our pizza coupon and car insurance analogies. If you are in possession of a pizza coupon, you are "long" the coupon and have the right, not the obligation, to buy one pizza for a fixed price over a given time period. In the real world, you do not buy pizza coupons; they are handed out for free. But that doesn’t put an end to our analogy because the basic idea is still there. Since you are holding the coupon, that means you posess the right to use it, and that’s the role of the long position. The pizza storeowner would be "short" the coupon and has an obligation to sell you the pizza if you choose to use your coupon. You have the right; he has the obligation.

If you buy an auto insurance policy you are "long" the policy and have the right to "put" your car back to the insurance company. The insurance company is "short" the policy; it receives money in exchange for the potential obligation of having to buy your car from you. Whether you make a claim or not, the insurance company keeps your premium just as you will when selling options. That’s its compensation for accepting the risk.

In the real world of car insurance, you cannot just force the insurance company to buy the car back for any reason. There are certain conditions that must be met; for example, the car must be damaged or stolen. You can’t just obligate the insurance company because you don’t like it anymore or because it has depreciated. However, in the real world of put options, you can sell your stock at a fixed price for any reason while your put option is still in effect. There are no restrictions. Of course, you wouldn’t want to do that if the fixed price you’d receive is less than the current market price. The main point is that if you are long a put option, you call the shots. You have the rights. You have the "option" to decide. You have the right to sell your stock for that fixed price at any time during the time your "policy" is in effect.

To be continued…….

 

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