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MARNOR INVESTMENT PARTNERSHIP LLP
LET YOUR MONEY EARN YOU THE PROFIT YOU DESERVE
MARNOR INVESTMENT PARTNERSHIP
OPTIONS TRADING
INTRODUCTION TO OPTIONS TRADING
WHAT IS OPTIONS
Options are the most versatile trading instrument ever invented. Since options cost less than stock, they provide a high leverage approach to trading that can significantly limit the overall risk of a trade or provide additional income. Simply put, option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy (call) or sell (put) the underlying stock (or futures contract) at a specified price until the 3rd Friday of their expiration month. There are two kinds of options: calls and puts. Call options give us the right to buy the underlying asset. Put options give us the right to sell the underlying asset. It is essential to become familiar with the inner workings of both.
There are no margin requirements if we want to purchase an option because our risk is limited to the price of the option. In contrast, option sellers receive a credit in their account for selling an option and get to keep this amount if the option expires worthless. However, option sellers also have an obligation to buy (put) or sell (call) the underlying instrument if their option is exercised by an assigned option holder. Therefore, selling an option requires a healthy margin.
To trade options, we must be acquainted with the select terminology of the option market. The price at which an underlying stock can be purchased or sold if the option is exercised is called the strike price. Options are available in several strike prices above and below the current price of the underlying asset. Stocks priced below $25 per share usually have strike prices at 2 ½ dollar intervals. Stocks priced over $25 usually have strike prices at $5 dollar intervals.
The date the option expires is referred to as the expiration date. A stock option expires by close of business on the 3rd Friday of the expiration month. All listed options have options available for the current month and the next month as well as specific future months. Each stock has a corresponding cycle of months that they offer options in. There are three fixed expiration cycles available. Each cycle has a four-month interval:
January, April, July and October
February, May, August and November
March, June, September and December
HOW WE CAN USE OPTIONS
Options can be used in a variety of ways to profit from a rise or fall in the underlying market. The most basic strategies employ put and call options as a low capital means of garnering a profit on market movement. Options can also be used as insurance policies in a wide variety of trading scenarios. You probably have insurance on your car or house because it is the responsible and safe thing to do. Options provide the same kind of safety net for trades and investments. They also increase our leverage by enabling us to control the shares of a specific stock without tying up a large amount of capital in our trading account.
Options can be used to offer protection from a decline in the market price of a long underlying stock or an increase in the market price of a short underlying stock. They can enable you to buy a stock at a lower price, sell a stock at a higher price, or create additional income against a long or short stock position. You can also use option strategies to profit from a move in the price of the underlying asset regardless of market direction.
There are three general market directions: up, down, and sideways.
Exiting an Option Position
Once we own an option, there are three methods that can be used to make a profit or avoid loss: exercise it, offset it with another option, or let it expire worthless. By exercising an option we have purchased, we are choosing to take delivery of (call) or to sell (put) the underlying asset at the option's strike price. Only option buyers have the choice to exercise an option. Option sellers, on the other hand, may experience having an option assigned to an option holder and subsequently exercised.
Offsetting is a method of reversing the original transaction to exit the trade. If we bought a call, we have to sell the call with the same strike price and expiration. If we sold a call, we have to buy a call with the same strike price and expiration. If we bought a put, we have to sell a put with the same strike price and expiration. If we sold a put we have to buy a put with the same strike price and expiration. If we do not offset our position, then we have not officially exited the trade.
If an option has not been offset or exercised by expiration, the option expires worthless. If we originally sold an option, then we want it to expire worthless because then we get to keep the credit we received from the option premium. Since an option seller wants an option to expire worthless, the passage of time is an option seller's friend and an option buyer's enemy. If we bought an option, the premium is non refundable even if we let the option expire worthless. As an option gets closer to expiration, it decreases in value.
CALL OPTIONS
Call options give the buyer the right, but not the obligation, to purchase an underlying asset. They are available in various strike prices depending on the current market price of the underlying instrument. Expiration dates can vary from one month out to more than a year (LEAPS options). Depending on the mood of the market, we may choose to buy (go long) or sell (go short) a call option.
PUT OPTIONS
Put options give the buyer the right, but not the obligation, to sell an underlying asset at the strike price until market close on the 3rd Friday of the expiration month. Just like call options, put options come in various strike prices depending on the current market price of the underlying instrument with a variety of expiration dates. Expiration dates can vary from one month out to more than a year (LEAPS options). However, unlike call options, we might consider going long a put option if we expect market prices to fall (bearish). In contrast, if we are bullish (expect the market to rise), we might consider selling a put option.
We emphasise that this is an oversimplified explanation of options. Due to its complexity we are not keen to explain in details the jargons and technicality of this subject.
We provide a basic understanding so that investors who are interested in the partnership will gain some insight into how the investment capital will be invested. We have provided a list with a number of links to various web pages. Options trading is one of the link for anyone interested in further reading on the subject.
