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- Options Trading 101 : From Theory to Application
- Options Trading From Theory to Application: Johnson, Bill: : Books
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As with call options, it is the long position that has the right while the short position has the obligation opposites. The long put, however, has the right to sell while the short put is required to buy opposites. This arrangement is required to make the options market work. Both parties the buyer and seller cannot have rights. They can neither both buy nor both sell. One side has the right to buy or the right to sell , while the opposite side has the obligation to complete the transaction. This arrangement is often a source of confusion for new traders.
They wonder how the option market can work if everybody has a right to buy or sell. The answer is that it is only the long position that has the rights. The short position has an obligation. It is important to understand this relationship when going through this book, especially when you get to strategies. We just learned that you can get into an option contract by either buying or selling a call or put. The answer is yes. All you have to do is enter a closing transaction also called a reversing trade.
In other words, you can always escape your obligations by simply doing the reverse set of actions that got you into the contract in the first place. This is much like you do with shares of stock if you are short. The price you pay to get out of the contract may be higher and, in some cases, much higher than the price you originally received from selling it — just as when shorting shares of stock.
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But the point is that you can get out of a short option contract by simply buying it back. If the idea of buying back a contract sounds confusing, think of the following analogy.
Options Trading 101: From Theory to Application
You probably have a cell phone are locked into some type of agreement such as a one-year contract. Cell companies do this to prevent people from continually shopping around and jumping to the hot promotion of the month. However, your cell provider will also have some type of buy back clause in the contract. The reason is that you bought the contract back — it no longer exists between you and the company. This is mathematically the same thing that happens when you buy back a contract in the options market.
Likewise, you can get out of long call option by simply doing the reverse; that is, selling the same contract that you own. Because of this possibility, most option traders simply trade the contracts back and forth in the open market rather than using them to buy or sell shares of stock.
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As we will later see, trading option contracts is a big advantage because they cost a fraction of the stock price. If you are in possession of a pizza coupon, you are long the coupon and have the right, not the obligation, to buy one pizza for a fixed price over a given time period. In the real world, you do not buy pizza coupons; they are handed out for free.
The pizza storeowner would be short the coupon and has an obligation to sell you the pizza if you choose to use your coupon. You have the right; he has the obligation. If you buy an auto insurance policy you are long the policy and have the right to put your car back to the insurance company. The insurance company is short the policy; it receives money in exchange for the potential obligation of having to buy your car from you. Whether you make a claim or not, the insurance company keeps your premium just as you will when selling options.
In the real world of car insurance, you cannot just force the insurance company to buy the car back for any reason. There are certain conditions that must be met; for example, the car must be damaged or stolen. However, in the real world of put options, you can sell your stock at a fixed price for any reason while your put option is still in effect. There are no restrictions. The main point is that if you are long a put option, you call the shots.
You have the rights. You have the option to decide. You have the right to sell your stock for that fixed price at any time during the time your policy is in effect.
Options Trading 101 : From Theory to Application
Okay, this may sound good in theory but how do you know that the short positions will actually follow through with their obligations if you decide to use your call or put option? The OCC is a highly capitalized and regulated agency that acts as a middleman to all transactions. When you buy an option, you are really buying it from the OCC. And when you sell an option, you are really selling it to the OCC. The OCC acts as the buyer to every seller and the seller to every buyer. It is the OCC that guarantees the performance of all contracts.
By performance we obviously do not mean profits but rather that if you decide to use your option, you are assured the transaction will go through. In fact, ever since the inception of the options market and the OCC in , not a single case of unfair or partial performance has ever occurred.
Options Trading From Theory to Application: Johnson, Bill: : Books
Key Concepts. We just covered the terms long and short, which are critical for understanding who has the right and who has the obligation with any particular strategy. But we have a lot more ground to cover before learning about strategies. Next, we must venture into the remaining terms we will be using throughout the book. In the pizza coupon example, we would say the underlying asset is a pizza. Notice that the coupon limited us to how many pizzas we can purchase; we cannot purchase all we want.
In addition, the coupon is not good for any brand of pizza but only the one advertised on the coupon. Call and put options work in similar ways. The underlying asset for a call or put option is generally shares of stock. But when options are first issued, they always represent shares of the underlying stock.
The brand of shares we can buy is determined by the call or put option.
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For example, if we have a Microsoft call option, we have the right to buy shares of Microsoft. In this case, Microsoft would be the underlying stock. The price of an option is tied to or derived by the underlying stock. Because of this, options are one of many types of derivative instruments. A derivative instrument is one whose value is derived by the value of another asset. Another name for the strike price is the exercise price.
The reason for this is that if you choose to use your option, you must submit exercise instructions to your broker, which is handled with a simple phone call. With a pizza coupon you just hand in the coupon, but in the world of options you must exercise the option through your broker. The exercise price is the price that will be paid by the long position and received by the short position. The opposite is true for put options. The short put will pay the strike price since he is the required to buy the stock.