Optin Box close
Welcome to the Options University Blog

This is no ordinary ebook. Options 101 just hit the bookstore shelves all over the country. It's available at Amazon.com and BarnesandNoble.com and we've been told it's the 'best options book on the market today'.

Because we feel that a proper foundation in options is critical to your success,
We'd Like To Offer You
3 FREE Chapters
of Our NEW Book
Options 101:
From Theory to Application
by Options Expert Bill Johnson
To get your 3 FREE chapters, simply enter your name and email address below, and we'll send these to you right away
(You'll have them in your email inbox instantly!).
"It's fun for me to spend time with people that are really bright and passionate about something that I love as well. Options University has done a wonderful job of getting their message across in an easy to understand way. I hope this is the first of many..."

Tom Sosnoff
thinkorswim, inc.
Name:
E-mail Address:

Jul

19

Options University’s Options 101 - Part 6

Filed Under Options 101 

Options 101
Part 6
 
Physical versus Cash Delivery
 
If you exercise an equity option, you will either buy or sell the actual (physical) shares of the underlying stock. This is called physical delivery or physical settlement.
 
On the other hand, most index options, such as SPX (S&P 500), are cash settlement rather than physical delivery. In other words, if the long position exercises an index option, he receives the cash value of the option rather than taking actual delivery of all the stocks in that index. Just realize that not all options settle in physical delivery. As you continue to learn more about options you will hear the terms “physical settlement” and “cash settlement,” and it’s important you understand what these terms mean.
 
 
Exercise versus Assign
 
We said earlier that it is the long positions who get to exercise their options. What do short positions get to do? Nothing. Remember, short positions have no rights. The short position may get a phone call from his broker stating that he has just purchased or sold shares of stock due to a call option he sold. If you are required to buy or sell shares of stock due to a short option, it is called an assignment.
 
If you get assigned on an option, your broker will notify you the next business day to inform you of the assignment. He may say something like, “I’m calling to inform you that you’ve been assigned on your short call options and have sold 100 shares for the strike price of $50.”
 
The words exercise and assign should only be associated with long and short positions respectively. However, in the real world, if you are assigned on a short option, brokers may say things like “you got exercised” on an option even though it is technically incorrect. Long positions exercise. Short positions get assigned. In truth, it doesn’t really matter in practice if an incorrect phrase is used such as “you got exercised” rather than “you got assigned” as long as you understand the message. However, if these terms are used, you do need to understand the difference. Most books and literature on options carefully choose between the words “exercise” and “assign” and you need to understand the actions they are referring to.
 
Let’s work through some examples to be sure you understand. If you are long a call option, you have the right to exercise it and buy shares of stock. If you are short the call, you might get assigned and be required to sell shares. If you are long a put option, you have the right to exercise it and sell shares. If you are short the put option, you could get assigned and be required to buy shares. To continue further, if a long call holder uses his call to buy shares of stock he would say, “I exercised my call.” The short call holder would say, “I got assigned on my call.”
 
It is important to understand that once you submit exercise instructions to your broker and the shares and cash have exchanged hands it is an irrevocable transaction. Make sure you want to exercise before submitting instructions. Also, many firms have cutoff times after which exercise instructions cannot be changed (even though the shares or cash may not have yet been exchanged). Check with your broker as to what these cutoff times are before you submit exercise instructions.
 
Option Basics
 
You now have enough information to understand some hypothetical call and put options. These two assets – calls and puts – are the building blocks for every option strategy you will ever encounter. This is why it is crucial that you understand the rights and obligations that they convey. Most confusion with option strategies stem from not understanding (or simply forgetting) who has the right and who has the obligation.
 
Because options are binding contracts, they are traded in units called contracts. Stocks are traded in shares; options are traded in contracts. An option contract, just like a pizza coupon, will always be designated by the underlying stock it controls along with the expiration month and strike price. For example, let’s assume we are looking at a Microsoft June $30 call.
 
We’ll soon show you where you can look up actual option quotes and symbols for options, but for now let’s make sure you understand what this option represents.
 
Using your understanding of pizza coupons, what do you suppose the buyer of one contract is allowed to do? The buyer of this call has the right (not the obligation) to purchase 100 shares of the underlying stock – Microsoft – for $30 per share at any time through the third Friday in June. (Remember that the expiration date for stock options is always the third Friday of the expiration month.) The buyer of this coupon is “locked in” to the $30 price no matter how high Microsoft shares may be trading. Obviously, the higher Microsoft trades, the more valuable the call option becomes.
 
To understand this concept a little better, assume that you have found a piece of property valued at $300,000 and wish to buy it. But you’d first like spend a few days researching the area before buying it. If you do, you’ll run the risk of losing it to another investor. What can you do? You can go to the broker and put down some money to hold the property for you. For instance, you may pay $500 for several days worth of time. If you decide against the property, you lose the $500. These arrangements are done all the time in real estate and are called “options” on real estate. Assume that you pay the $500 for five days worth of time and are now locked into a binding agreement to buy the property for $300,000 over the next five days. Now suppose that some news is spreading that the area is about to be commercially zoned and some big businesses are interested in it. Property in the area goes up dramatically overnight. But even if you decide to not buy the property, don’t you think that somebody else would love to be in possession of the contract that you have giving them the right to pay $300,000? Of course they would. And these people will start offering you large amounts of money to persuade you to sign over the contract to them. You could just sell it to them and they could sell it to others. This is exactly what most traders do with the equity options market.
 
Now let’s go back to our option example. How much will it cost you to use (exercise) your call option? Because you are buying 100 shares of stock, the strike price must be multiplied by 100 as well. If you were to exercise this Microsoft $30 call option, you would pay the $30 strike * 100 shares = $3,000 cash. This is called the total contract value or the exercise value. In exchange for that payment, you’d receive 100 shares of Microsoft. It works just like a pizza coupon. You pay a fixed amount of cash and receive some type of underlying asset. Most brokers charge a standard stock commission to exercise your options. If you exercised this call, your broker would probably charge you his regular commission for buying 100 shares of stock. After all, the long call option is simply a means for buying regular shares of stock.
 
To restate a previous point, it is important to understand that if you buy call or put options, you are not required to ever buy or sell shares of stock. Further, you do not ever need the shares of stock in your account at any time. Most option contracts are opened and closed in the open market without a single share of stock changing hands. Even though you’re allowed to purchase or sell stock with your options, most traders never do. Instead, they just buy and sell the contracts in the open market amongst other traders.
 
Now let’s assume we are looking at a Microsoft June $30 put option. Think about your auto insurance policy and try to figure out what this option allows you to do. If you buy this put option, you have the right to sell 100 shares of Microsoft for $30 per share at any time through the third Friday in June. Because you are locking in a selling price, put options become more valuable as the stock price falls. If you exercise this put option, you are selling 100 shares of Microsoft, which means you will have 100 shares of Microsoft taken from your account and delivered to someone else. In exchange, you will receive the $30 strike * 100 shares = $3,000 cash. If you exercise this put, your broker will probably charge the regular stock commission for selling 100 shares of stock since the put option is simply a means for selling regular shares of stock.
 
What if you only wish to buy or sell fewer than 100 shares of stock? You can do that but in a roundabout way. Using the call example above, let’s say you only wanted to buy 60 shares of Microsoft for $30. You would still exercise the call option for 100 shares and then immediately submit an order to sell 40 shares (which would carry a separate commission). Each contract is good for 100 shares and you must buy and sell in that amount. But there’s nothing stopping you from immediately entering another order to customize those amounts to suit your needs. Likewise, if you exercised a put option but only wanted to sell 60 shares of stock, you would have to exercise the put and sell 100 shares and then immediately place an order to buy 40 shares.
 
To be continued…

Share This

Comments

Leave a Reply

You must be logged in to post a comment.

Close
E-mail It