Using Options as Shares of Stock
By Bill Johnson 

Options are powerful. Options are versatile. But some stock traders are convinced that options are risky, and they continue to trade stock that puts them at a disadvantage. For this article, let’s take a look at how options can be used as shares of stock.

To master options trading, you must understand that it’s the option’s time value that makes it an option. If an option is made up entirely of intrinsic value and now time value, it’s not an option – it’s stock. For example, let’s say one trader buys shares of stock trading for $110, but another buys a $100 call trading for $10. That call’s price is entirely intrinsic value – the difference between the $110 stock price and the $100 strike. In options trading terms, this option is trading at parity, which means it’s equivalent to shares of stock.

To see why, pick any stock price above the $100 strike, and the $100 call owner and stock owner will perform identically. If the stock is $115, the stock buyer makes $5 and so does the call buyer. If the stock is $130, both traders make $20. On the other hand, if the stock price drops to the $100 strike, the options trader and stock trader both lose $10 – again, neither trader better or worse off than the other.

However, if the stock price falls below the $100 strike, that relationship changes, and the options trader will outperform the stock buyer. The options trader can’t lose any more than the initial $10 paid, but the stock buyer continues to lose. In other words, if the stock price falls below the $100 strike, you’re better off holding the option. By holding the shares of stock, you can’t do better – but you could do worse. There is a benefit in holding the option, and that’s why you’ll usually pay a time value. It’s the price the option’s buyer pays for the protection of losses below the strike.

In the real world of trading, it’s rare to see an option trading for parity, except when the option is about to expire. However, by choosing an option strike that’s deep in the money, you can greatly reduce the time value and therefore make the option behave nearly identical to the shares of stock – but with big benefits.

For instance, on June 25, Home Depot (HD) closed at $196.38. If you wanted to buy 100 shares, it would cost nearly $20,000. However, the January 2019 $150 call with 207 days to expiration was trading for $48.38. The breakeven price $198.38 – exactly $2 greater than the current stock price. That additional $2 is the time value, which provides the insurance against losses should the stock’s price fall below the $150 strike at expiration.

Pick any stock price above the $150 strike, and the option buyer just gives up the $2 time value compared to the stock trader. If the stock price falls below $148, the option buyer outperforms the stock buyer. In the chart below, you can see there’s very little difference between the red line (stock) and the blue line ($150 call) for all stock prices above $148. The two lines nearly overlap and are only separated by the $2 time value. However, below $148, the stock trader continues to take losses whereas the options trader’s loss is limited to the $48.38 premium paid:

Now consider the benefits. By paying $48.38 for the call, you’re spending less than 25% of the stock’s price. The best leverage you can get as a stock trader is 25% – and but you must close the position by the end of the day. The options trader, however, may continue to hold. Further, the options trader will never pay margin interest or receive a maintenance call. The options trader has more money to diversify into other trades – or average into positions across time. These are all things the stock trader cannot do as efficiently, but it only cost the options trader the $2 time value.

Options don’t have to be options. By understanding the art and science of options trading, you can make options behave like shares of stock– but for far less cost and much bigger advantages.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results. CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here

What Makes an Option an Option?
By Bill Johnson 

Humorist Artemis Ward once said, “It ain’t so much thing things we don’t know that get us in trouble. It’s the things we know that just ain’t so.”

The options markets are filled with myths and misperceptions that prevent traders from using them to their fullest potential. One of the biggest misconceptions is that of cheap and expensive options. If you ask most traders, they’ll tell you that a cheap option is any that cost three dollars or less. While an expensive option cost more. In other words, they’ll have an arbitrary line in the sand to differentiate between cheap and expensive options.

However, professional traders know that it’s the extrinsic value, or the time value, that makes an option an option. If you have an option that’s made up entirely of intrinsic value, it’s not even an option – it’s stock. For instance, let’s say the underlying stock is trading for $120. If the $100 call is trading for $20, it’s entirely made up of intrinsic value and no extrinsic value. There’s not a single option in that deal. This is a condition called “parity,” which just means the option is trading equivalently to shares of stock. And if it’s trading just like stock, there’s no option in it. Even though it may look like an expensive option, it’s nothing but cheap shares of stock with a free insurance policy attached.

To see why, let’s say you bought this call while your friend bought shares of stock. If the stock price falls from $120 all the way down to $100 at expiration, your friend loses $20 and so do you. There’s no difference at all. However, if the stock continues to slide, your friend continues to lose while you’re limited to just the $20 loss. Because your losses are limited to $20, it’s as if you have an insurance policy that you didn’t have to pay for. That’s why you’ll rarely find options trading at parity unless you’re really close to expiration.

However, let’s say this $100 call was trading for $21 rather than $20. Now there’s $20 of intrinsic value and one dollar’s worth of extrinsic value. How much is this option?

Most new traders will say it’s a $21 option. A professional trader will tell you it’s a one-dollar option because that’s the amount you’re paying for the insurance policy. It’s this one-dollar value that will separate you and your friend’s performances. For instance, if the stock falls to $100, your friend loses $20 – but you’ll lose $21. You’re worse off by one dollar because that’s what you paid for the “option” or the right to walk away from the deal. In other words, you’re not required to buy the shares of stock, but your friend already committed to it.

If the stock’s price continues to slide below $100, your friend continues to lose, but you’ll limit your losses to $21. It’s the one-dollar extrinsic value that you paid for the “insurance” policy.

Understanding the art and science of options trading is necessary for success, and the interplay between intrinsic and extrinsic values is a great start. Most traders know the relationships, but if you look closer, they may know things that just ain’t so.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results. CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here

The Power of Using Vertical Spreads to Roll
By Bill Johnson 

In a previous article, I talked about the power of rolling your long call options up as the stock price rises or rolling your put strikes down if the stock price falls. By rolling, you can lock in gains but still hold on for bigger profits. You capture the best of both worlds, as you’re not trying to time the tops and bottoms, but instead are capturing the bulk of the stock price movement — all while greatly limiting risk.

However, new traders often break a roll into two separate trades, and that’s a mistake. For instance, let’s say a trader buys a $50 call for $5. If the stock price rises sufficiently, he may wish to roll it to the $55 strike by first selling the $50 call, say for $7. Once that trade is executed, he’ll immediately place a second trade to buy the $55 call, say for $3.

By selling for $7 but spending $3, the trader has received a net credit of $4 between the two trades. Because he initially spent $5, he’s holding the $55 call for a net debit of one dollar. In other words, by rolling to the $55 call, the trader has reduced his maximum loss from the initial $5 price to only one dollar. However, he still has unlimited upside potential. By rolling the position, he can hang on for bigger profits while continually sweeping cash into the account. On his next roll, he’ll be in a position where he has a guaranteed profit – but will continue to earn more money if the stock price continues to climb.

The trader did the right thing by rolling from the $50 call to the $55 call; however, he went about it the wrong way. By breaking the roll into two separate trades, it subjected him to execution risk – the risk of adverse stock price movement between trades.

To see how execution risk works, let’s go back to the rolling trade where the trader ended up with a net credit of $4. But let’s say while he’s setting up his first order to sell the $50 call, the stock price dips a little bit, and he ends up receiving less than $7, say $6.90. Next, as he’s setting up his order to buy the $55 call, the stock price begins to tick back up. Rather than paying $3, he ends up spending $3.10. Now he ends up with a net credit of $3.80 rather than $4, and it was strictly due to adverse stock price movement while he was setting up the trade – that’s execution risk. How can this be prevented?

Rather than placing two separate trades, the trader should have placed a vertical spread by simultaneously selling the $50 call and buying the $55 call. In trading terms, he’s selling the 50/55 vertical spread for a net credit of four dollars. However, once the trade is executed, he won’t be holding a short vertical spread. Why?

The short $50 call from the vertical spread cancels the original long $50 call. Those end up disappearing from the account. The only position left is the long $55 call — exactly the same result as when he split up the two trades. Well, if it’s the same result, what’s the benefit?

By using a vertical spread, the difference between the two option prices – the $4 credit – tends to remain constant regardless of what’s happening to the stock’s price. If the stock price dips a little bit while he’s setting up the order, he’ll receive less money for selling his $50 call, but he’ll also pay less for his new long $55 call. The result is that he’ll still receive the $4 credit he was expecting. On the other hand, if the stock price rises while he’s setting up the order, he’ll spend more for the $55 call, but he’ll also receive more for the $50 call he’s selling. Again, the result is that the net $4 credit will remain the same.

Avoiding execution risk is the reason professional traders always use simultaneous trades to execute any type of roll, whether moving to different strikes or different expirations. Of course, depending on the roll, they won’t always be using a vertical spread. It may be a calendar spread, butterfly, or any other number of strategies. By understanding execution risk, it gives another powerful benefit of understanding options strategies: You may not plan to use the strategies by themselves, but they may be invaluable tools for rolling the positions you use most often.

Execution risk is another small force that works against you while you put the power of rolling in your favor. Make the two forces work together, and it’s money in the bank.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results. CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here

Bulls, Bears, and Beauty Pageants
By Bill Johnson

Stock traders have many choices of investments and an even bigger selection of technical indicators. However, they all share one thing in common: They rely on price movement, or volatility, for profit. The bigger the volatility, the bigger the price moves, the bigger the profits for the trader who is right – and the bigger the losses for the one who is wrong.

Options allow you to hedge volatility – or profit from it – by using a variety of strategies that allow you to partition risks and rewards in ways that cannot be done with shares of stock. That’s a big benefit, but to make it work, you can’t just approach the options based on whether you’re bullish or bearish. You must realize understand the role of volatility. However, even volatility poses a problem, as the price of options contracts don’t depend on whether the crowd is bullish or bearish. The price depends on what the crowd thinks the crowd thinks. To understand why, we need to look at an unlikely starting point – how to judge a beauty pageant.

The Economics of Beauty Pageants

In 1936, renowned British economist John Maynard Keynes explained price fluctuations in his masterwork, General Theory of Employment, Interest, and Money. There he drew the analogy that traders in a financial market make decisions much like participants of a beauty contest run by a local London paper at that time. The paper would run 100 photographs of women considered to be the most beautiful. Readers were asked to choose a set of six faces and everyone who picked the most popular face won a prize.

If you wanted to participate, it seems you should look through the photos and pick the six faces you think are the prettiest. However, a better “judge” wishing to win the contest wouldn’t use such a strategy. Instead, that reader will choose the six faces he suspects will be considered the prettiest by most of the people. But why stop there? A more sophisticated “judge” will take this reasoning into account and attempt to second guess the other judges’ second guessing – and so on and so on. Each level attempts to predict the selections based on the reasoning of other judges. As Keynes stated, “It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”

Keynes believed a similar process creates volatility in the stock market. Traders don’t price shares or options based on their fundamental or technical view, but instead on what they think everyone else thinks the value will be. It’s also why speculative bubbles can form. It’s not irrational to buy a “grossly overvalued” stock – if you feel everyone thinks the price will be even higher in the future. Asset valuation is a constantly moving target and that’s why prices can be so volatile.
This poses a problem for traders. As suggested by Keynes, to succeed at trading, you must be good at “mob psychology,” but that is a never-ending cycle of second-guessing the second-guesser. That’s the difficult and inconsistent way to invest. However, there’s a second choice that gives you more flexibility and consistency in your results, a choice that allows you to manage the inherent unpredictability of prices.

The Option Advantage

Options are the only assets that allows you to customize the risks you’re willing to accept. Most stock traders cut profits short because of the fear of holding the position. Trends generally last much longer than expected, and traders end up missing out on the many great rewards they set out to capture. Options help you to safely capture the missing money.

For instance, if buying call options, you can roll your call option up as the stock price rises. Doing so, you can roll your profit and loss curve above zero, as shown by the green curve in the chart below:

By having the entire curve sitting above zero, you can’t lose – but you may do better. On the other hand, what if you’re more fearful the stock price may fall? You may choose to leg into a backspread as shown by the blue curve. By entering a single trade, you can shift from the green curve to the blue curve. By sitting on the blue curve, you can make more money if the stock price falls, but it comes at the expense of fewer profits if the stock price rises.

If you want more profits if the stock price falls, you can shift from the green to the red curve. There’s now more profits if the stock price falls, but you have limited profits if it rises. The possibilities are endless, but you must understand the option advantage to easily switch as stock prices – and volatility – changes.

Richard Buckminster Fuller once said, “When I’m working on a problem, I never think about beauty. I think only how to solve the problem. But when I have finished, if the solution is not beautiful, I know it is wrong.”

Volatility poses a problem for stock traders. Options provide a beautiful solution.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

Trading the Mark:The Hidden Importance of Fair Value
By Bill Johnson

Vincent Van Gogh said, “Great things are done by a series of small things brought together.” Investing works much the same way, and financial success comes from doing a lot of small things correctly. Options, however, have a lot of moving parts, and it’s easy to overlook the things you can’t see. One of the biggest mistakes I’ve seen with new options traders – and experienced ones – is misunderstanding the importance of fair value.

Fair value is a financial concept, which is simply a price that neither benefits the buyer nor the seller in the long run. In other words, it’s a price that’s fair to both parties. If the price always benefited the buyer, traders would bid the price higher until that benefit was priced away. On the other hand, if the price always favored the seller, more sellers would enter the market, push prices lower, and eventually that benefit would disappear. But when we reach a balancing point and have a price that doesn’t benefit either party in the long run, it’s a fairly-valued asset.

To understand the concept of fair value, consider a coin toss. If I toss a coin and offer to pay you one dollar if it lands heads, you should be willing to pay me one dollar if it lands tails. If you do, neither of us would be expected to come out ahead if we played this game thousands of times. We would expect to just break even in the long run.

However, if you paid me just slightly more, say $1.05 each time it lands tails, it would no longer be fairly valued, and I would have a long-term edge. In fact, if we played this game one thousand times, you’d end up on the losing side of the bet, as shown in computerized simulation below:

In other words, because you’re paying more than fair value, you’re heading into a financial black hole. No matter what strategies you try, or what methods you concoct, you’re going to lose money. It’s like the old business school joke of the guy who sold inventory at a loss but tried to make up for it in volume. The more you play the game, the deeper in debt you go.

The concept of fair value is exactly what allows casinos to win in the long run. Casinos make money by paying off winners at less than fair value. If you win $1,000 at roulette, it might look like you came out ahead, but if you compared it to the odds you overcame to win that money, you were short changed. Contrary to popular belief, it is the winners who pay for the pleasure of gambling. In other words, the winners actually lose. The idea to understand is that when you pay above fair value or receive less than fair value, it’s a little thing that magnifies into big losses.

Options trading works the same way. Every options contract has a fair value, which can be found through a pricing model. Most platforms will show them as the “mark,” or the midpoint between the bid and the ask. However, most traders get impatient and buy their options at the asking price and sell them on the bid. Doing so, however, you subject yourself to a house edge on the way in – and on the way out. Without even counting the effects of commissions, it’s most likely going to lead to long-term losses. For instance, look at the screenshot of the Nvidia (NVDA) quotes below:

The stock was trading for $250, and the $250 call had a mark of $10, as shown in the third column. However, if you bought the option on the asking price (column 2), you’d pay $10.10, or 10 cents higher than fair value. On the other hand, if you sold the option for the $9.90 bid (column 1), you received 10 cents less than fair value. It seems like a small thing, and it probably is for a trade here or there. But if you keep buying on the asking price and selling at the bid, those little things add up to big losses. To make great strategies come alive, you must do a lot of little things well. Start by placing your options orders as limit orders at the mark. Be patient. If it doesn’t fill, it’s a missed opportunity, but that’s better than a filled order above fair value.

Options traders have a host of strategies available to them that simply aren’t available to stock traders. By using options, traders can hedge, roll, and morph positions, which allows them to stay in trends much longer than they would be willing to by using shares of stock. That’s where the big money lies. It’s exciting – and rewarding. But to master the art and science of options trading, you can’t just focus on the big strategies. To make them great, you must bring small things together.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

Trading in the Stock Market, Trading Options, Trading Futures, and Options on Futures, involves substantial risk of loss and is not suitable for all investors. Past Performance is not indicative of future results. CandlestickForum.com, Candlestick-Trading-Forum.com, StephenBigalow.com, and Candlestick Forum LLC do not recommend or endorse any specific trading system or method. We recommend that you research all trading systems, methods and market strategies thoroughly. Full Disclaimer here

Options Pricing: It’s Like Buying in Bulk
By Bill Johnson

One of the benefits of options is that we get lots of choices. We have lots of expiration dates, strikes, and strategies. Unfortunately, having so many choices also causes confusion among traders. Which expiration and which strike should you choose?

To answer that, it helps to understand some basics of options pricing. Most traders believe that at-the-money option prices follow a straight-line path. For instance, if a one- month option costs $1, you’d think a two-month option must cost $2 – twice the time, twice the money. It seems to make sense, but it’s wrong. Not understanding how options are priced leads traders to make bad strategy decisions.

It’s counterintuitive, but here’s the way it works: If a one-month option costs $1, it would take a four-month option before you’d see it trading for $2. In other words, it takes four times the amount of time to double an option’s price. The reason is that options prices are proportional to volatility, which is proportional to the square root of time.

If you increase time by a factor of four, the option’s price increases by the square root of four, or a factor of two. If you can increase in option’s time to expiration nine-fold, the option’s price triples.

The point to understand is that when you’re buying long-dated options, it’s like buying things in bulk. Yes, you’ll pay more for the option, but the price per day is greatly reduced. For instance, the four-month option trading for $2 costs about 1.7 cents per day, but the one-month option trading for $1 costs about 3.3 cents per day – twice as much. If you’re buying options, you should lean toward buying longer-dated options as the amount of time value you’re spending per day is greatly reduced.

On the other hand, option sellers should lean toward selling shorter-term options multiple times rather than selling one longer-dated option. For example, if you’re using a covered call strategy, you may decide to sell the four-month option for two dollars. It sounds like a better deal since you’re receiving $2 rather than $1. However, you must wait the entire four months before you’ll collect it all. On the other hand, if you sell the one-month option four times, you’ll collect $4 – twice as much money for the same length of time.

Unfortunately, many new traders think longer dated options are riskier because they cost more money in total. However, you must always ask yourself how much am I paying per day? When you look at options in this light, longer dated options are always far cheaper. For a live example, Apple Computer (AAPL) closed today at $187.63. If you decided to sell the January 2019 $190 call (242 days to expiration), you’d receive $12.30. However, if you sold the $190 weekly that expires in four days, you’d get 54 cents. Instead, if you sold the 4-day call, you could do that 60 times during the same 242 days, which would net a total of $32 – far greater than $12.30.

There are other considerations, such as the size of the hedge. If Apple takes a big hit, you may have been better off having sold the longer-dated option. But all things being equal, you should buy longer-dated options and sell shorter-dated ones. The square-root pricing relationship is the reason. All options strategies are always about tradeoffs, so there’s never a crystal-clear answer as to what the best strategy may be. Instead, you want to focus on which strategy is best for you. Once you understand how options are priced, it puts you one step closer to mastering the art and science of options trading.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!

The Hidden Dangers of Automatic Exercise
By Bill Johnson

Options strategies are highly rewarding, but like any field, there are rules and procedures you must understand. One of the most misunderstood – and potentially dangerous – is automatic exercise.

When you buy an option – call or put – you have the right, not the obligation, to exercise the option. If you exercise a call option, you’ll buy 100 shares of stock and pay the strike price. On the other hand, if you exercise a put option, you’ll sell 100 shares of stock and receive the strike price. You’re not required to ever exercise a long option. It’s simply a right if you choose. Most the time, options traders just close their options in the open market and take their profits that way. Still, some traders may want to buy or sell shares of stock by exercising an option, and they’re certainly free to do that.

However, there is a procedure set by the Options Clearing Corporation (OCC) that can potentially change that decision. If any option is at least one cent in the money, it is automatically exercised unless you instruct the broker to not do so. For example, let’s say you own the $100 call, and the stock closes at $100.01 or higher at expiration. If you didn’t close at call out at expiration, it will automatically be exercised, and that means you’re going to own 100 shares of stock on Monday morning. On the other hand, if you own a $100 put and the stock closes at $99.99 or lower, you’ll end up selling 100 shares of stock from your account. If you don’t have the stock in the account, you’ll be short 100 shares of stock. What if you don’t have to cash in the account to maintain the long or short stock positions?

Most brokers will still exercise the options, and you’ll owe at least a 50% margin requirement to continue holding the position. Some brokers, however, will close the position if you don’t have the cash, so it’s important to understand your broker’s policies.

Losing More Than What You Paid

The main danger with automatic exercise is that it creates the potential for you to lose more on the option than the amount you paid. You often hear that the most you can lose on an option is the amount you paid, and that means the option itself cannot have negative value. However, because of this man-made rule of automatic exercise, it’s not totally true.

Here’s an example of how things can go wrong if you don’t understand option mechanics. Let’s say you bought a $100 call for $3, or a total of $300. On expiration Friday, the stock is trading for $99.50, and it looks like it’s going to expire worthless. Rather than paying the commission to close it out, you take off for the golf course. However, in the last few minutes of trading, news breaks out, and the stock closes above $100. Because you didn’t close out the option, you’re going to be long 100 shares of stock on Monday morning. Now let’s say the stock trades at $95 on the opening bell. You own shares at $100, but if you don’t want the shares in your account, you’re going to end up selling them for the current market price of $95. Therefore, you ended up with a $500 loss, even though you only spent $300 on the option. The reason this happens is the long $100 call has a limited downside risk of $3 – the amount you paid. It’s profit and loss diagram looks like a hockey stick as shown by the blue curve in the chart below:

However, if you end up exercising that call, whether intentionally or through automatic exercise, your profit and loss diagram is no longer represented by the blue curve. Instead, you’re now long shares of stock and have an unlimited downside risk as shown by the red line.

The lesson to learn is that if you have any long options that are even remotely close to becoming in the money at expiration, close them out. If your proceeds are not enough to cover commissions, most brokers will call it even. If your broker won’t, you can always place instructions to not exercise any long options that may end up going in the money. If you either close out the long positions or instruct the broker to not exercise them, now it’s safe to go to the golf course. Options aren’t risky if you understand all the rules. As Warren buffet said, risk comes from not knowing what you’re doing. If you understand the art and science of options trading, they’ll become invaluable tools for hedging risk and holding on for bigger gains.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with multi-pay options!