Chapter 4 Using the Option Chains – The Options Trading Primer

CHAPTER 4

Using the Option Chains

Examining and Using Option Chains

This chapter dives deeper into the use of option chains, examining how to:

  • Use the extensive information displayed on option chains
  • Use the Greek values displayed at each strike price and what they mean
  • Use the current implied volatility (IV%) to determine buying and selling opportunities
  • Understand how to use ± Price Movement values
  • Evaluate the current Open Interest values when selecting one or more strike prices
  • Find, copy, and paste option codes used with conditional order (stops and profit targets)
  • Add two or more strikes (or legs) to create option strategies
  • Edit quantities, prices, strikes, expiration dates, prices, etc. on the order bar
  • Display risk profiles to determine how trades respond to price changes
  • Set up and configure a bracketed trade
  • Roll working orders up, down, and/or out
  • Review and submit orders from the order confirmation dialog

At the Money, In the Money, Out of the Money Review

Examine the call and put sections of the option chain in Figure 4.1 on the following page. It is separated into two sections to make the text and numbers larger and easier to read. Notice that it is set to display 14 strikes, that is, seven strikes having values lower than the ATM strike and seven above, although only five strikes are shown in the illustration. The $125 strike is closest to the current price, $125.21, of GLD. Traders use expressions like “below the money,” “near the money,” “far out of the money,” and so on.

Now look at the ATM strike’s Delta values on the put and call sides. Notice how the Delta values of both the call and put are quite close to .50. This is typical of the Delta values that are closest to the ATM money strike. The value of Delta decreases incrementally between strikes as the strikes move farther out of the money (OTM) or deeper in the money (ITM). This is because Gamma, which is used to calculate the values of Delta, is highest ATM and declines in value as it moves farther away from the ATM strike. Also recall from Table 2.1 how each Delta’s value is used to compute the change in premium values for each $1.00 change in the price of the underlying stock. This tells us that the Mark values of those strikes that are closer to the ATM strike change more than when farther OTM. You can verify this fact by looking at the difference in the Mark values from one strike to the next.

Also notice how the Mark values, or the premium traders pay or receive, increases in value as the strike prices drop on the call side of the option chain. Now examine the put side of the option chain to see how the Mark value of the puts increases as the price of the underlying decreases. Both of these moves are referred to as “moving deeper in the money.”

Now look for the implied volatility (IV%) of 9.89 percent located above the Open Interest column on the put side of the option chain. This is an indication of current trading volume relative to the average trading volume over the past 12 months. The 9.89 percent IV value is quite low but will likely return to historical levels unless the enterprise that the stock represents is experiencing a decline in business operations, which may have caused a reduction in trading.

The ±3.725 is referred to as the price movement. This is a mathematical derivative of the IV% value and is the calculated price movement that is expected throughout the life of the option, that is, through expiration. These values are extremely sensitive to changes in trading volume. And at such a low IV% of 9.89 percent, an increase in both the IV% and the price movement values are likely. This is an excellent value for buying call options if bullish or put options if bearish, because the IV% is likely to increase in value as it returns toward its historical volatility level. When the IV% value increases back toward historical volatility levels, premium values increase.

Recall how option traders look for high volatility values when selling options and low volatility values when buying options. Experienced option traders always examine volatility values prior to trading because volatility influences premium values more than any of the other so-called option Greeks, that is, Gamma, Delta, Theta, Vega, or Rho. Volatility values are discussed again in the order rules narrative provided in Chapter 5.

Buying, Selling, and Buying and Selling

An introduction to several common option strategies was included in Chapter 2. These strategies bought and sold puts and calls, combined puts and calls into vertical spreads—an extremely heavily used options trading construct—and also described strategies that combined both call and put vertical spreads, like the extremely popular iron condor strategy.

Most trading platforms support up to four option legs. The iron condor, described in the Buying and Selling Put and Call Spreads section of Chapter 2, is an example of a trade that includes four different strike prices, that is, a short and long call and a short and long put.

When trading two or more different option contracts at different strikes, they are displayed on the order bar located at the bottom of the option chain. An option chain and order bar for the iron condor mentioned previously is shown in Figure 4.2.

Notice how the trade includes four “legs,” a short and a long call and a short and a long put. Also be aware of how we click on the Bid cell to sell options and the Ask cell to buy options. Here are the steps you can use:

  1. Click the Bid cell on the 140 call strike row.
  2. Press and hold the Ctrl key while clicking the Ask cell on the 150 call strike row.
  3. Press and hold the Ctrl key while clicking the Bid cell on the 115 put strike row.
  4. Press and hold the Ctrl key while clicking the Ask cell on the 110 put strike row.

Notice how the short options are both at or below Delta .25. This Delta value is used because when this trade was entered, the five short puts and calls had a 25 percent or better probability of remaining OTM through option expirations in 16 days. (Find the expiration date and (16) in Figure 4.2.) Traders have used Delta values for years in the same way as Probability ITM is used. Although the market often makes unexpected moves, using Delta for determining the probability of a strike price to remain OTM for a successful trading outcome works more often than not. The key is to never “overtrade” by putting too much money at risk.

Being able to determine the odds of a successful outcome through option math is only one reason the popularity of options is on the rise. But unless prospective traders read a book like this one or take an option trading course, they will never know how to use option math.

Now look at the Open Interest values of each strike. The Open Interest values, which show current working trades at each strike, appear to be ample. Strong Open Interest helps working orders fill faster. When an order fills, you are probably “trading seats” with the trader on the other side of your trade. However, trades that include multiple strikes, especially four, are often difficult to fill. Some traders buy and sell multiple-leg trades two strikes at a time. In this iron condor example, this would entail selling an iron condor in two separate transactions: a vertical bear call spread—the short call and long call above, and a vertical bull put spread—the short put and long put below. Be aware that entering two separate orders increases your trading overhead because it requires you to pay two brokerage commissions.

Using the Order Bar

The following order bar is created as each of the option trades is selected (Figure 4.3).

Notice the values in each section of the order bar.

 

Spread: The name of the spread, in this case, IRON CONDOR

Side: This can be either SELL or BUY.

Qty: The number of contracts to buy or sell; the five can be incremented or decremented manually or preset as the default value. Notice + is BUY and is SELL.

Symbol: The ticker symbol of the underlying stock, ETF, financial index, and so on.

Exp: The option contract expiration date(s)

Strike: The selected strike prices of each option

Link: This section is blank unless a MARKET or STOP order is used. When a STOPLIMIT, TRAILSTOP, or TRAILSTOPLIMIT order is used, the Link section displays the following:

STOPLIMIT: MAN for Manually; requires the trader to type a stop limit order value in the Price section of the order bar.

TRAILSTOP: MARK for Market; type a trailing stop value as a MARKET order value in the Price section of the order bar.

TRAILSTOPLIMIT: MAN for Manual; type a TRAILING STOP LIMIT value line with MARK, which is a market order.

Price: The debit to be paid or credit to be received when entering an order

Order: A Limit order is the default. Other order types are selectable from a drop-down list, including Market, Stop, Stop Limit, and Trailing Stop Limit.

TIF for Time in Force (): Either good till canceled (GTC) or a Day order, which expires at the end of the current trading day

Exchange: BEST designates the use of the exchange that offers the best transaction price(s)

 

This order bar illustrates a limit order configured to sell five puts at the $277 strike. It also includes a protective market stop order designed to trigger if the SPY price drops to $278 (Figure 4.4). Notice the stop order is a GTC and will exist as a working order unless triggered by a drop in the price of SPY to $278. You can think of this as a “conditional order” that is triggered if the price of LGND breaches $278. If the 277 put option is not filled during the trading day, both orders expire unfilled.

Setting Up a Bracketed Trade on an Order Bar

Bracketed trades can be set up in a few different ways. For example, a trader can use the order bars at the bottom of the option chain to set up a bracketed trade. This requires the use of an advanced order type such as a first triggers all order. Other selections like first triggers sequence, one cancels other (OCO), first triggers OCO, first triggers two OCO, and so on, are also available. Learn what’s available on your trading platform, their meanings, and how to use them.

Trading platforms also include trade setup dialogs, or Order Rules, that provide access to a variety of order setups and dependencies. Be sure to examine these dialogs and the way they work on your trading platform. If unsure about how to set an order up, check with your brokerage’s support team. This is why they’re there, and they are usually quite helpful.

Examine the order bar in Figure 4.5. This illustrates the first step in the creation of a bracketed trade on the order bar at the bottom of the option chain. The example begins with a bull put vertical spread that sells five short puts above five long puts and collects .24 cents for $120 in premium.

Now the trader can add a profit target and protective stop. But first, the order is changed to a 1st trgs OCO, for first triggers one cancels other. This setup cancels one order when the other one is triggered. Therefore, if the profit target is used, the stop order is canceled (Figure 4.6).

Once the 1st trgs OCO is selected (#1 arrow), some trading platforms permit the trader to open either a shortcut menu (#2 arrow) or a drop-down-style menu. The menu is used to create two opposite orders—one as a profit target and the other as a protective stop. The protective stop can be configured either as a limit order or as a market order, which is entirely up to the trader. In this example, two limit orders are used (Figure 4.7).

Once the opposite order bars are added, the order column is used to configure the brackets. Notice the profit target Price is set to 15 cents and the Order type is set to LIMIT, GTC. If this 24-cent DAY order is filled, the stop orders begin working. If the MARK drops to 15 cents for a $90 profit, the order is triggered, and the OCO cancels the other side of the bracket. If the Mark rallies to 30 cents, the protective STOPLIMIT/GTC order triggers, and the OCO cancels the profit target order. This bracketed trade works in exactly the same way as targets and stops work with stocks.

There are more variations to bracketed trades and stop order triggers, such as using a Delta-triggered stop order or a stop based on a Bid or Ask price value. These can be configured to either take profits or to limit losses. Every competent trader of stocks, options, or futures learns how to construct and submit bracketed trades. All include protective stops and one to three profit targets.

Examining an Order Confirmation

The order confirmation dialog should be carefully examined to confirm the order details. But high-frequency day traders, also called pattern day traders, often suppress the order confirmation dialog in order to expedite the submission of their trades to the market. They want their orders to enter the market as quickly as possible. And they use a series of bracketed order templates with limit orders, protective stops, and limit profit targets that permit them to scan stock charts and enter their trades with a single mouse click. Speed is essential, particularly on stocks with fast-moving price levels. They do not want to wait for the order confirmation dialog and miss an opportunity to quickly scalp a fast price move for a quick profit.

But most swing traders who may make two or three trades each morning to perhaps a dozen or more a week usually check their trade setups on an order confirmation dialog before submitting their trades. Swing traders got their name because they take advantage of price swings in underlying securities.

Examine the information provided in the order confirmation dialog shown in Figure 4.8. Look at each of these lines, beginning with the top line and working your way down. As you can see, this information, especially the potential profit to loss, or reward-to-risk ratio, is not particularly attractive. If the trader permits this bull put vertical spread to expire in the money, the trader would have to pay $25 per share for 500 shares of JD stock, a total of $12,500 plus commissions less the initial $120 premium credit received when the trade was filled. Once the stock is put to the trader, it can be sold to recover all but $630.00—a benefit provided by a vertical spread. Or the trader could keep and use the stock with a series of covered call options.

Finally, most traders look for much lower reward-to-risk ratios than the one displayed in the order confirmation dialog. The $120 max profit is only 19.04 percent of the max loss. Probably not an acceptable ratio unless the odds are extremely favorable for the short put to remain OTM through expiration.

 

#1 Order Description: The trade description including the strategy, strikes, and expiration

#2 Order Description: The trade description of the limit profit order that closes the vertical spread for $0.15 per share

#3 Order Description: The trade description of the protective limit stop order that is triggered if the premium (Mark) value breaches 30 cents

Break Even on Stock Prices: This line usually displays the stock price required to achieve breakeven, which is usually displayed when the strikes can be calculated

Max Profit: The maximum profit potential

Max Loss: The maximum loss potential excluding dividends when the stock is owned

Cost of Trade including commissions: The debit or credit paid or received when this trade is filled

Buying Power Effect: The reduction in available margin used when this trade is filled

Resulting Buying Power for Stock: The residual stock buying power in the trader’s account

Resulting Buying Power for Options: The residual option buying power in the trader’s account

Single Account/Account: Trader’s account number(s); choose from a drop-down list

Delete/Edit: Delete the order or edit the order

 

Adding and Removing Option Chain Columns

Most full-featured trading applications, or trading platforms, include option chains, price charts, and watch lists. Some even include stock and option scanners. These scanners permit traders to set up search parameters to find and list ticker symbols that meet established parameters such as average daily trading volumes, the low-to-high price range, current volatility levels, current price trends, and so on. Some traders also include one or more oversold or overbought ranges using one of several available momentum oscillators that are often used on price charts. Three examples of popular momentum oscillators are the relative strength index (RSI), commodity channel index (CCI), and the moving average convergence/divergence (MACD). These and others, such as one of a few stochastic oscillators, are frequently viewed on price charts by technical analysts.

Regardless of how an option trader scans for his or her stock picks, once the stock is viewed on the option chain, the trader uses the information on the option chain to decide on the structure and placement of an option trade. This includes the selection of a bullish, neutral, or bearish strategy, the strike price(s), and one or more option expiration dates. For example, when a trader is bullish and buys a call on a stock trending upward, a long-term option contract is used to give the stock’s price ample time to increase in value. Or, if selling an OTM put contract for a credit, the trader collects premium from the sale of the option. If the option remains safely OTM, the trader can either close the trade within a few weeks for a profit or let it expire worthless for 100 percent profit. When short options are permitted to expire OTM and worthless, the trader is not required to pay a trading commission or option exchange fees.

Examine Figure 4.9, which illustrates a typical option chain customization dialog. Notice there is a long list of available columns on the left-hand side of the dialog, while only six columns are used.

Figure 4.10 shows the seven selected column headings on the put side of an option chain. Using too many columns creates unnecessary clutter. Therefore, many traders rarely use more than five or six columns on each side of the central strike column unless using a large wide-screen monitor. But there are times when we want to check one or more specific values, such as the Extrinsic (time) value remaining in an in the money short option. Adding the current Mark and Extrinsic value provides the cost to exercise the selected strike, plus commissions. Adding the Extrinsic and Intrinsic values is equal to the Mark value. (Recall that the Mark is the premium value that traders pay for options when bought or collect when an option is sold.)

This is frequently true of long-term options, such as a LEAPS options. (LEAPS stands for long-term equity anticipation securities, which are long-term options that expire in 1 year or more). When the sum of the Mark and Intrinsic values exceeds the amount option buyers must pay to exercise an in the money short option, the trade is rejected to prevent the buyer from losing money by spending more money than the option is worth. As the option approaches expiration and/or it moves deeper in the money, however, it becomes vulnerable to being exercised. So checking the Extrinsic value of a short option can be important.

In addition to extrinsic value, there is also intrinsic value. The sum of the Extrinsic and Intrinsic values is equal to the Mark (or premium) value of each option.

The analysis of the underlying stock is enhanced by examining additional values provided on its option chains. Most option chains provide a customization feature in the form of a shortcut or drop-down menu that lists available columns. In addition to an option chain’s default values that include the Strike prices and the corresponding Bid and Ask columns, the customization menu lists several column headings that are easily added or removed with a few mouse clicks.

Adjusting the Number of Strike Rows

You can expand or reduce the number of displayed strikes by selecting a number from the Strike drop down, typing a number, such as 40 to show 20 strikes above and below the ATM strike, or select ALL to examine all available strike prices. Displaying ALL can be in the hundreds, especially for financial index options such as the S&P 500 (symbol SPX) or the Nasdaq 100 (symbol NDX). However, if trading within 10 or 20 strikes of the ATM price, you may want to display 40 or 50 strikes to eliminate the extra time required to scroll up and down.

Bid, Ask, and Mark

The width between the Bid and Ask price values is typically narrow on stocks with high trading volumes, and wide on stocks with low trading volumes. This is a good sign of liquidity. When trading volume is strong, trade orders tend to fill rapidly. And the narrow Bid-to-Ask price range of a heavily traded stock or index also helps to fill a trade because traders are more willing to give up a few pennies to fill a trade than to adjust their sell (Bid) or buy (Ask) prices by 10 or more cents per share to fill an order.

Wide Bid-to-Ask spreads create what is referred to as slippage. Slippage occurs when traders are required to slide their price up or down to finally get their trades to fill. Every experienced trader has experienced “chasing” a trade by moving a Bid or Ask price up or down to get their opening and exiting orders to fill. Of course, it’s more important to close a losing trade to cut off a major loss than to open a trade.

Open Interest (Liquidity)

Open Interest is another option chain column that experienced option traders examine. Open Interest values are an important indication of liquidity. It shows the number of working trades at each strike price. High Open Interest values encourage trade entry because it indicates strong interest in the selected equity and in one or more specific strike prices. There are two Open Interest “rules of thumb” you should consider.

One- or two-strike option strategies: (10 × the number of contracts). This suggests we should use 10 × the number of contracts when trading one- or two-strike option strategies.

Examples

 

Selling a cash covered put

Buying an ATM or slightly OTM long call

Selling an OTM put and buying an OTM put below (the bull put vertical spread)

Buying an ATM call and selling an OTM call above (the bull call vertical spread)

 

Open Interest Value(s)

 

Example: Five contracts require an Open Interest value of 50; there should also be a few thousand in total Open Interest above, below, and on the opposite side of the option chain.

Three- or four-strike option strategies: (Open Interest of 300 at each selected strike price)

Examples: (+1 = buy one; 2 = sell 2)

Long call butterfly: +1 ATM call, 2 calls 1 strike above, +1 call 1 strike above

Iron condor: 1 OTM put, +1 OTM 2 strikes below; 1 OTM call, +1 OTM call 2 strikes above

There should also be at least 5,000 in total Open Interest above, below, and on the opposite side of the option chain.

Avoid the use of strikes that have small Open Interest values.

 

The “Greeks” (Gamma, Delta, Theta, Vega, Rho)

The Greeks were briefly introduced in Chapter 2 and described in Table 2.1. Here, we look at them again in substantially more detail. Although Rho can be impactual on option premium values, causing premium values to increase in value faster owing to the “cost of money,” traders rarely look at this Greek or display it on their option chains owing to currently low interest rates. Rho has not been impactual on premium prices for some time. In any case, each of the Greek values mentioned earlier is described in the narratives that follow.

Gamma

Figure 4.11 illustrates how the amount of time remaining until expiration influences the value of Gamma.

To further clarify the impact of Gamma, a Gamma value of .04 changes Delta’s value by .04 for each one dollar move in the underlying security, such as a stock. Because there are many factors that influence option pricing, calculations are codependent. Changes in Vega and Theta also influence the value of Gamma and its Delta derivative.

Gamma values are positive and negative depending on where they are found on an option chain. For example, long calls, puts, and debit spreads have positive Gamma values. Short calls, puts, and credit spreads have negative Gamma values.

There is a Gamma-Delta-neutral option spread that uses both Delta and Gamma values to determine the number of long and short contracts required to set up the trade. A third leg used in this strategy involves shorting the underlying stock to achieve neutrality among the three legs of the spread. Each share of stock has a Delta value of 1.0—a fact that is used in the Gamma-Delta neutral spread. Each share of a shorted stock has a Delta value of 1.0. Strike prices of deep in the money puts can have Delta values of 1.0. Deep in the money calls can have Delta values of +1.0.

Delta

Delta measures the directional risk present in every option strategy. As you may recall from Chapter 2, Delta values at strike prices closest to the price of the underlying (the at the money strike price) is typically at or quite close to 0.5. The value of Gamma is the highest at this strike price. Figure 4.11 shows the Delta and Gamma values of a series of near-the-money call options that are within 10 days of option expiration.

The Delta values of call and put options change from positive to negative depending on whether the options are bought or sold. Table 4.1 shows how the value of Delta responds to buying and selling.

There are some option trades that are referred to as being “Delta neutral.” This happens when the Delta values of a long call and a long put are identical; hence, the sum of the two Delta values is zero, referred to as being Delta neutral.

Vega (Volatility)

Of all the Greeks, Vega has the greatest impact on premium values, and this makes sense because it measures current volatility—the measure of current buying and selling volumes. The value of Vega increases as volatility increases and declines as volatility decreases. Vega is tied directly to the current volatility of the underlying optionable security. Recall from the previous chapter how the Vega responds to a 1 percent change in the volatility of the underlying security. Here’s an example of how Vega influences premium values.

  • At a certain strike price, the current premium value is $1.50 and Vega is .20.
  • The volatility of the underlying security increases by 1 percent.
  • The current .20 Vega is multiplied by $1.50 + 0.20 = $1.70.
  • A 1 percent reduction in volatility would reduce the premium value from $1.50 (1 × 0.20) = $1.30.

Vega values displayed on option chains are always positive. Certain spreads can produce net negative Vega values. One example is when a trader buys near-the-money option contracts with a 4.5 Vega and sells OTM option contracts with an 8.5 Vega value. Summing the short 8.5 Vega and the long 4.5 Vega produces 4.0 Vegas.

Option traders look upon Vega as a measure of risk or reward resulting from changes in volatility. A trader’s bias and the option strategy the trader uses are most often based on current volatility. Premiums are high when implied volatility is high—a good time to sell options for income. Option premiums are cheaper when implied (current) volatility is unusually low—the best time to consider buying options while they are cheap.

Looking at several option chains quickly reveals how the value of Vega increases with the extension of time. More distant expiration dates have higher Vega values than those on options that are approaching their expiration dates. In addition, Vega is also highest at those strike prices closest to the money. Look at the Vega values in Figure 4.12. Notice how the values of Vega increase relative to the time remaining till expiration and decrease as the strikes move farther OTM.

Theta (Time Value)

The Greek Theta on an option chain and the amount of time remaining in the underlying contract are tightly coupled. The value of Theta tells option traders how much premium value is exiting with the passage of each day. When Theta values are plotted on a graph with 90 days until expiration, the plot begins with a slight downward slope. When it reaches 30 days till expiration, the slope begins to turn downward quite rapidly. Figure 4.13 illustrates the slope of Theta from 90 days through expiration.

Notice how the value of Theta increases as the contract approaches expiration in Figure 4.14. The value exiting each of the four option chains increases with the passage of time. With nine days remaining, Theta tells us how the premium value is exiting at a rate of $0.07 cents per share per day, or $7.00 per day for each 100-share contract. With 149 days remaining, Theta is only –.03, the premium value is exiting at a rate of $3.00 per day per contract.

Theta is both useful and easy to read. Option buyers pay close attention to the value of Theta. When the daily depreciation begins to signal an unacceptable loss, a buyer will enter a sell to close order in an attempt to recover what premium value may remain. Of course, it’s possible to wait too long to close a trade that’s soured, because nobody will want to trade chairs and take your seat. When this happens, the only benefit may be a tax write-down.

The seller on the opposite side of the same contract benefits from the rising value of Theta as the contract approaches expiration. This gives the seller several choices:

  1. Let the contract expire worthless, and keep all of the original premium as profit.
  2. Buy to close by paying substantially less premium than originally received.
  3. Wait a little longer to exit for even more profit.
  4. Roll the position to a later expiration date for additional premium income. This requires the strike price to remain far enough OTM to return an acceptable premium value.

Rho (Rate of Interest)

Rho measures each option’s sensitivity to changes in current interest rates. Like Vega, interest rate changes impact longer-term options that expire in several months much more than those that expire in a matter of weeks or days. Rho is positive for long calls as higher interest rates increase the premium values of calls. Rho is negative for long puts; high interest rates decrease put premiums. (Recall that the Mark value at each strike is the premium value.)

Rho (the rate of interest) impacts premium values because it impacts the cost of carrying a trade over time. In this respect, Rho is similar to Vega. As mentioned in the preceding paragraph, increases in Rho (higher interest rates) impact longer-term options much more than short-term options. Interest rates are used in the underlying option pricing models that calculate option premium values. The pricing formulas consider option prices based on what is referred to as the “hedged value.”

A “hedge” example is when a trader uses long or short options to hedge against a drop or rally in the price of a stock. Long put options are frequently bought to hedge (or offset) a portion of the loss in the price of the stock; long calls are used to hedge increases in short stocks values.

Rho is positive for purchased calls as higher interest rates increase call premiums. Conversely, Rho is negative for purchased puts, because an increase in the rate of interest decreases put premium values.

American and European Expiration-Style Options

Options have two expiration styles called American and European. The difference is in when an ITM option can be exercised. Most popular options are American-style. This is true for both put and call options. In the money American expiration-style options can be exercised for profit by buyers. European-style expiration options cannot be exercised prior to contract expiration. In fact, European-style options are automatically exercised if the option seller permits them to expire in the money. When an option seller permits his/her short options to expire in the money, the Extrinsic (time) value is completely depleted. Unless the option’s buyer notifies his or her brokerage to withhold exercise privileges, the ITM short call or put options are auto-exercised by the OCC when the options are in the money by just one penny.

Exercising Options, Assigning Options, and the Function of the OCC

The Options Clearing Corporation (OCC) is responsible for clearing all option contracts that expire in the money by one penny. As mentioned in the previous paragraph, a buyer may be required to pay commissions and exchange fees that exceed his or her profit potential that may be in the pennies. When this is the case, the option buyer can notify the brokerage to withhold his or her exercise privilege to cancel an unwanted stock assignment transaction. Another important OCC function is to set and maintain option expiration schedules. Although the Chicago Board of Options Exchange (CBOE) produces options and calculates their values, the OCC is responsible for option expiration schedules.

Call Option Buyers and Sellers

When short calls are either exercised prior to expiration or permitted to expire in the money, the call option sellers are required to deliver the optioned stock to the call option buyers. In exchange, the buyers are required to pay for the stock at the option’s strike price. For example, if a $50 stock option expires at $53, the option is $3.00 in the money. The buyer can pay $50 per share for the stock plus commissions. The stock is worth $53 per share. This is a $3.00 per share or $300 per option contract profit less trading overhead.

Put Option Buyers and Sellers

When a short put is exercised or expires in the money, the buyer delivers the stock to the seller, who must pay for the stock at the put option’s strike price. An example of this exchange would be for the buyer and seller to trade a $55 stock option. The stock drops to $50 per share, and the buyer exercises the option on the last day of the option contract prior to market close. The buyer delivers the stock that’s now worth $50 per share to the seller, who pays the buyer $55 per share for the $50 stock. The buyer earns $5 per share in profit, or about $500 per contract, less transaction costs. Because the Extrinsic (time) value is only a few pennies a share (the time till expiration is only a matter of an hour or two) the transaction fees are likely to be around $20. If the exchange includes five contracts, the buyer will earn nearly $2,500.

Option Strategy Selection and Terminology

The flexibility of options provides a broad and diverse range of trading strategies. All include buying, selling, or, more often than not, a combination of buying and selling as in vertical spreads. Option trades can include one to four strikes, call options, put options, or a combination of call and put options. They can also include one or more expiration dates. And some even include shares of stock.

Although there are descriptive names for most common options strategies, there are several names that are nonsensical, as, for instance, Jade Lizards, Twisted Sisters, Iron Condors, and some others. As you can see in Figures 5.9 and 6.27, the iron condor’s risk profile (or risk graph) resembles a big bird with a large square body between the short put and call strikes, which are represented by two wings that drop below the zero axis on the x–y plot. It’s likely that someone described the plot lines as a condor. The twisted sister is an iron condor without the usual OTM long call, and the jade lizard is an iron condor without the usual OTM long put. Risk profiles are described and illustrated in Chapter 6.

When either buying or selling options, you now know that traders always look for liquidity. This is seen in the trading volume of the underlying stock, as well as in the Open Interest values shown on option chains. Liquidity is extremely important when either entering or closing any kind of trade. We want demand for options that are either bought or sold. And, of course, it’s more important to be able to close your options either for profit or to limit your losses than it is to fill opening orders. So always watch the Open Interest values. (More about this in the trading rules in Chapter 5. Open Interest values were also discussed earlier in this chapter.)

When selling call or put options, option traders consider several things. In addition to examining the underlying price charts in order to develop a trading bias—bullish, neutral, or bearish—traders also look at the amount of time remaining until expiration, current volatility, the Delta values, and, of course, the Mark values and the Bid-to-Ask spread widths. All of these and more are described in detail in Chapter 5’s trading rules. But as you know from earlier narratives in this book, option traders do not want their short puts or calls to become in the money. Therefore, they sell their calls and puts at strikes they believe will remain OTM throughout the life of the trade. They choose option expiration dates to limit the amount of time the market has to move against their trade. Both require traders to settle for a few dollars less in premium in order to limit their risk. On the other hand, they choose stocks that currently have relatively high IV% values that are either at or exceed 40 percent. As you probably know by now, higher IV% values boost premium values, which is better for option sellers. These and several other factors give option traders an edge because they increase their probability of achieving successful trade outcomes.

In contrast, when they buy call or put options, option traders must be confident in their trading biases. They vet the underlying stock by examining the price charts over several different time intervals, that is, 3 years, 1 year, 1 or 2 hours, and perhaps 5 minutes. (Day traders may look at even lower time intervals, including tick charts that display a “candle” for each 10 to 50 trades.) When buying calls, most option traders choose stocks having upward trending prices, typically off historical support levels. (Recall the demand and support zones described in Chapter 3.) When buying puts, they consider stocks with prices trending downward off supply levels. And they choose longer contract terms that typically exceed 90 days till expiration. Some choose LEAPS options that expire in one or more years. Some who buy LEAPS options may also examine underlying fundamentals just as a buy-and-hold stock trader would.

The added time increases the option’s extrinsic values, making them more costly when traded. But if the trader’s bias is correct, the return can be enormous. In fact, trades that buy at the money calls and sell at the money puts, called a synthetic long stock, are very popular, because the premium paid for the long calls is offset by the premium credit received from the short puts. If the underlying rallies according to the trader’s strong bullish bias, this trade can return an enormous profit. (Note that the term synthetic is used when one equity type is used to simulate another. In the synthetic long stock strategy, options are used to simulate the purchase of a long stock.) Entering this option strategy is relatively inexpensive. But the trader must be right in his or her bullish bias to achieve a successful outcome; otherwise, this trade can lead to a substantial loss.

When buying calls and puts, we want current volatility levels to be low—such as when the implied volatility percentage displayed on the option chain is at or below 15 percent. This reduces the premium values paid, making buying the calls or puts cheaper. When low volatility returns to historical levels, the premiums rise in value. Hence, the trader may sell the calls or puts for a profit. Giving the trade more time for an increase in volatility can certainly help.

Chapter 5 discusses these and other trading analytics, that is, common-sense trading rules that option traders use to enhance the probability of achieving successful trading outcomes.

Caution: Never Slide Protective Stops to Save a Bad Trade!

Most experienced traders know never to slide a protective stop that would potentially increase their losses. Veteran traders carefully choose their protective stop values on the basis of what they are willing to lose. But inexperienced amateurs often think a price move against them is temporary. They convince themselves that the move against them will reverse direction. But the market doesn’t care. Realistically, that reversal may never occur. This can be devastating, and it happens every day! Experienced traders simply “take their medicine.” They calculate the value of their stops to be affordable. And although their rules-based trades are usually successful, they also know that there will always be a few losing trades along the way. Stand on 18 in blackjack, because you’ll usually win.

If your trading rules average seven winners out of every 10 trades, then a losing trade means your next trade has 7-in-2 odds for a successful outcome. Sliding stops based on hope is rarely rewarded. In fact, some traders have blown out their entire accounts because they hoped an unwanted price move would reverse direction. Never trade on hope, fear, or even what you hear. Trade only what you see!