Birthing Option Contracts - dummies

By Joe Duarte

There is an important difference between what it takes to issue new shares of stock and how options contracts come to exist. The number of shares available to trade in a particular stock is called the float.

If there is a need for more stock to be issued, shareholders vote on whether it is sensible or not to do so, and the company goes through a process of registration before the new shares are offered to the public.

It’s different with options, where the potential number of contracts possible is limitless because options contracts are offered based on demand. The actual number of existing contracts for any option is known as the open interest.

Opening and closing positions

When you enter your order to buy an option, there may or may not be a ­contract available. But you won’t know that since your demand will create a ­contract if one isn’t already available. The important factor is how you enter and exit positions. The type of order you enter will lead to the execution of the trade.

Attention to detail is very important, so you need to pay close attention to how you enter your order, and that means specifying whether you are opening a new position or closing an existing one. To buy a call option, you would enter the following order:

Buy to Open, 1 XYZ June 21 35.00 strike call option

To exit the position, you would enter the following order:

Sell to Close, 1 XYZ June 21, 35.00 strike call option

The same type of order format applies to opening a position in an option that you don’t own. The important factor is the correct use of language and the specificity of the option you are selling. Use the following to sell an option you don’t own:

Sell to Open, 1 XYZ June 27 42.00 strike call option

Buy to Close, 1 XYZ June 27 42.00 strike call option

When you enter your orders correctly, it allows the exchange and the clearing company to keep accurate track of the number of open contracts, which is also known as the open interest, and to keep tabs on the number of contracts traded on any given day. The open interest number displayed on options contract quotes has a one‐day delay, meaning that today’s number is accurate up to the prior day’s action.

If you make a mistake when entering an order, contact your broker immediately. The error should be readily fixable both in your account and at the exchanges.

Selling an option you don’t own

When you sell an option as an opening transaction, you are obligated to sell a stock at the strike price at any time until the option expires. During that period, if a call option holder decides to exercise their rights, you may have to meet your obligation.

When this happens, it’s called being assigned the option, and your broker will contact you to inform you about it. When you are assigned on a call option contract, you must weigh two possibilities:

  • If you own shares of the underlying stock, you must sell the shares and close the stock position.

  • If you don’t own the shares of the underlying, and you don’t sell the shares, you have created a short position in your account.

The easy part of selling an option that you don’t own is putting in your order. The more important part is understanding the risk of the trade. If you own shares when you sell a call option, it is known as a covered transaction, because the shares cover the short call position. If you don’t own the shares when you sell the call, it’s called a naked call. What makes this strategy most dangerous is that it has the same risk as a stock short position. In other words, your risk of loss is unlimited, given the potential of a stock to continue to rise indefinitely.

When you sell a put option as an opening transaction, you are obligated to buy a specified amount of stock at the predetermined strike price at any point until the option expires. You own this obligation from the time you open the transaction until the expiration weekend and you are require to satisfy the obligation if a put option holder decides to exercise their right.

Getting assigned on a short put usually happens when the underlying stock has declined. If assigned you will be buying stock at a higher price than the current market value. Your short put transaction can also be covered or naked.

When you sell a put short, you are under obligation to buy shares, so you cover the position with a short stock position in the underlying. Buying the shares closes the short stock position. If you sold a naked put and you are assigned, you will have a new long position in your account.

Selling puts is a tricky transaction, so it takes a little time to figure it out. Here is why:

  • When you take on the obligation associated with this transaction, you are no longer making active decisions with regard to the transactions involving the underlying stock.

  • The risks associated with the short option transactions are very different, depending on whether you have a covered or naked transaction.