Options Basics- Terminology.
A call option gives the buyer the right, but not the obligation, to buy the underlying instrument (in this case, a stock) at a predetermined price (the strike price) on or before a predetermined date (option expiration). For example, if you buy September 50 XYZ calls, you have the right, but not the obligation, to buy XYZ at $50 per share any time between now and the September expiration. This type of option can be very valuable in the event of a significant move above $50. Each option contract you buy is for 100 shares. The amount the trader pays for the option is called the premium.
There are two values to the option, the intrinsic value and the extrinsic value, or time premium. Intrinsic value is also referred to as the option’s moneyness. Using our XYZ example, if the stock is trading at $55, your September 50 calls have $5 of intrinsic value. If the calls are trading at $6, that extra dollar is the time premium. If the stock is trading at $48 and your option is trading at $2, the option only has time premium and is said to be out of the money.
Option sellers write the option in exchange for receiving the premium from the option buyer. They are expecting the option to expire worthless and, therefore, keep the premium. For some traders, the disadvantage of writing options naked is the unlimited risk. When you are an option buyer, your risk is limited to the premium you paid for the option. But when you are a seller, you assume unlimited risk.
Refer back to our XYZ example. The seller of that option has given the buyer the right to buy XYZ at 50. If the stock goes to 60 and the buyer exercises the option, the option seller will be selling XYZ at $50. If the seller does not own the underlying stock, he or she will have to buy it on the open market for $60 to sell it at $50. Clearly, the more the stock’s price increases, the greater the risk for the seller.
How can a covered call help?
In the covered call strategy, we are going to assume the role of the option seller. However, we are not going to assume unlimited risk because we will already own the underlying stock. This gives rise to the term “covered” call – you are covered against unlimited losses in the event that the option goes in the money and is exercised.
The covered call strategy is twofold. First, you already own the stock. It needn’t be in 100 share blocks, but it will need to be at least 100 shares. You will then sell, or write, one call option for each multiple of 100 shares (i.e. 100 shares = 1 call, 200 shares = 2 calls, 276 shares = 2 calls).
When using the covered call strategy you have slightly different risk considerations than you do if you own the stock outright. You do get to keep the premium you receive when you sell the option, but if the stock goes above the strike price, you have capped the amount you can make. If the stock goes lower, you are not able to simply sell the stock; you will need to buy back the option as well.
There are a number of reasons traders employ covered calls. The most obvious is to produce income on stock that is already in your portfolio. Others like the idea of profiting from option premium time decay, but do not like the unlimited risk of writing options uncovered.
A good use of this strategy may be for a stock that you might be holding and that you want to keep as a long-term hold, possibly for tax or dividend purposes. You feel that in the current market environment, the stock value is not likely to appreciate, or it might drop some. As a result, you may decide to write covered calls against your existing position.
Alternatively, many traders look for opportunities on options they feel are overvalued and will offer a good return. To enter a covered call position on a stock you do not own, you should simultaneously buy the stock and sell the call. Remember when doing this that the stock may go down in value. In order to exit the position entirely, you would need to buy back the option and sell the stock.
What To Do at Expiration
Eventually, we will reach expiration day. What do you do then?
If the option is still out of the money it is likely that it will just expire worthless and not be exercised. In this case, you need do nothing. If you still want to hold the position, you could “roll out” and write another option against your stock further out in time. Although there is the possibility that an out of the money option will be exercised, this is extremely rare.
If the option is in the money, you can expect the option to be exercised. Depending on your brokerage firm, it is very possible that you don’t need to worry about this; everything will be automatic when the stock is called away. What you do need to be aware of, however, is what, if any, fees will be charged in this situation. You will need to be aware of this so that you can plan appropriately when determining whether writing a given covered call will be profitable.
The option trading risks pertaining to options buyers are:
1. Risk of losing your entire investment in a relatively short period of time.
2. The risk of losing your entire investment increases as the option goes out of the money (OTM) and as expiration nears.
3. Specific exercise provisions of a specific option contract may create risks.
4. Regulatory agencies may impose exercise restrictions, which stops you from realizing value.
The option trading risks pertaining to options sellers are:
1. Options sold may be exercised at anytime before expiration.
2. Covered Call traders forgo the right to profit when the underlying stock rises above the strike price of the call options sold and continues to risk a loss due to a decline in the underlying stock.
3. Writers of Naked Call Write risk unlimited losses if the underlying stock rises.
4. Writers of Naked Put Write risk unlimited losses if the underlying stock drops.
5. Writers of naked positions run margin risks if the position goes into significant losses. Such risks may include liquidation by the broker.
6. Writers of call options can lose more money than a short seller of that stock on the same rise on that underlying stock. This is an example of how the leverage in options can work against the option trader.
7. Writers of Naked Call Write are obligated to deliver shares of the underlyng stock if those call options are exercised.
8. Call options can be exercised outside of market hours such that effective remedy actions cannot be performed by the writer of those options.
9. Writers of stock options are obligated under the options that they sold even if a trading market is not available or that they are unable to perform a closing transaction.
10. The value of the underlying stock may surge or ditch unexpectedly, leading to automatic exercises.
Other option trading risks are:
1. The complexity of some option strategies is a significant risk on its own (i.e. Options trading is likely inappropriate for an inexperience or unsophisticated investor and not all financial advisors are qualified to trade options on behalf of their clients).
2. Option trading exchanges or markets and option contracts itself are open to changes at all times. The availability and conditions of which are not to be taken to be permenant.
3. Options markets has the right to halt the trading of any options, thus preventing investors from realizing value.
4. Risk of erroneous reporting of exercise value.
5. If an options brokerage firm goes insolvent, investors trading through that firm may be affected.
6. Internationally traded options have special risks due to timing across borders.
Option Trading Risks: The Official Word In Short
1. Naked options positions have unlimited loss potential.
2. Options can expire out of the money and worthless (thus all the money you put towards purchasing them).
3. Options leverage can work against you as much as it can work for you.
4. Obligations and rights of buyers and sellers.
5. Terms, conditions and policies of the specific option contract, options exchanges or options brokers can change at anytime.
Every of the above option trading risks can result in a catastropic loss of capital, that is why you must fully understand stock options so that you can lower the option trading risks posed by the above or determine whether options trading is even appropriate for you.
Option Trading Risks: 3 Macro Risk Factors
(1) Primary Risk (Market Risk)
Primary risk or Market risk is the risk that the overall market failed to move in your expected direction. If you are long calls on a whole portfolio of stocks then primary risk would be the risk that the market might crash, taking all your calls out of the money (OTM). In general, the more stocks and the more diversified the stocks that you invest in, the higher the chance that your portfolio will move as a whole closer to how the overall market is moving. Remember, the Dow that we know today is made up of 30 stocks. Buying shares or call options on these 30 stocks will give you a portfolio that moves exactly how the Dow is moving. This is a significant option trading risks if you are executing Long Call Options strategy across a wide portfolio of stocks.
(2) Secondary Risk (Sector Risk)
Secondary risk or Sector risk is the risk that a whole sector of stocks failed to do well. There are times when specific market sectors do not do well due to fundamental economic reasons, causing all stocks in those particular sectors to crash. This is a significant option trading risks for option traders who executes bullish strategies on stocks from only a couple of sectors.
(3) Idiosyncratic Risk (Individual Stock Risk)
Idiosyncratic risk is the risk that shares of a company you bought is effected by events that happens to that particular company. If you buy shares of XYZ company, you run the idiosyncratic risk of that company going bankrupt all of a sudden. This is an option trading risks that affects option traders who put all their money on the options of a single stock most.
Option Trading Risks: Directional Risk
Perhaps the next most significant option trading risks that affects most option traders is Directional Risk or Delta Risk. No matter what option strategies you choose to execute, the underlying stock needs to behave in the manner needed for that particular option strategy to turn a profit. For example, if you execute a Bull Call Spread on XYZ company’s stock, then that stock needs to rise before you can turn a profit. If your prediction is wrong, you can still lose money. Directional risks can be hedged using Delta Neutral Hedging.
Option Trading Risks: Conclusion
Options trading is risky and should only be down by seasoned professionals or very sophisticated investors.
If you have questions about options investments you made, or if you believe that you have been the victim of a securities fraud, The White Law Group may be able to help. To speak to a securities attorney, please call our Chicago office at 312-238-9650 for a free consultation.
The White Law Group is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida.
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