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How to Trade Options Primer

Many investors ask about the terminology of options and the difference between types of options. Here I share some background o the fundamentals of option trading. Bonus: An active option trade is shown below for our Covered Call of the Week.

An option is a standardized contract originated by the Options Clearing Corporation (OCC) that is exchange listed. A stock option is the legal right, but not obligation, to buy (calls) or sell (puts) shares of a specific stock, which is known as the underlying stock, for a fixed time and a fixed price. Stock options have two main characteristics:

Fixed Price: an option give the holder the right to buy or sell at a fixed price. This price is known as an exercise price or strike price (or just “strike”).

Limited Life: an option is good for only a specific period of time, then expires. If it expires without being exercised, it is said to “expire worthless.”

The Two Types of Options

There are two types of options to be used in your option strategy for various trades based on the prediction of the investor.

Calls: the right, but not the obligation, to buy the underlying stock.

Puts: The right, but not the obligation, to sell the underlying stock.

Buying and Selling Options Primer

ACTION

STATUS

CALL OPTION

PUT OPTION

Buy

Long

Holder has the right but not the obligation to buy 100 shares

Holder has the right but not the obligation to sell 100 shares

Sell

Short

Seller has the obligation tosell 100 shares if calls are exercised

Seller has the obligation to buy 100 shares if puts are exercised

Underlying Stock – these are the shares of stock that underlie (are subject to) a stock option. The underlying stock also can be an Exchange-Traded Fund (ETF) instead of a stock.

Option Contract – each exchange-listed call or put contract normally covers 100 shares. The only exception would be for a stock or reverse split, merger or other corporate recapitalization, which can result in an adjustment to the terms of an option contracts. There are over-the-counter options, but they are a different subject and not covered in this article.

Option Trading – standardized options contracts are exchange-listed and traded on the different U.S. option exchanges.

Expiration – stock options (equity options) expire on the Saturday following the 3rd Friday of each month and that Friday is the last day on which those options can trade. If the 3rd Friday is a holiday, the last trading day will be the Thursday before. Some brokerage firms institute a Friday deadline for notice of exercise by retail customers so be clear on whether you can exercise options on expiration day. Be aware that options you have sold can be exercised on expiration day.

Option Term – stock options have a life of 9 months or less unless they are LEAP options with a much longer life, up to three years. At the end of the term, the option expires.

Open Interest – the number of contracts of an option series outstanding. A proxy for how much interest among investors in this contract.

There is no risk that upon exercise of an option the other side will fail to perform. The OCC, the world’s largest clearing organization for options, processes all sales of put and call options and all option exercises. The OCC acts as the guarantor of every option transaction to ensure there are no option defaults.

In fact, there has never been a default in buying or selling shares upon call or put exercise, for this very reason. The OCC does not guarantee anyone a profit, however, only that shares will be bought (sold) upon call (put) exercise. Note that buyers and sellers of options do not form a contract with each other, there contract is with the OCC, which is the true counterparty to the option buyer or seller.

COVERED CALL of the WEEK

Covered Call on Baker Hughes (BHGE) 

STRATEGY: The BHGE Sep 20, 2019 covered call with a $21.00 strike price could potentially yield a 4.69% return if BHGE stays above $21.00 a share at expiration 33 days from now. The return covered call has a 3 Key (Moderate Relative Risk) ranking while the diagonal spread has a riskier 2 Key (Considerable Relative Risk) ranking. On 08/05/19, Argus Research set a $30.00 12-Month price target for BHGE, which is currently trading at $8.94 below that target. By using this covered call strategy potential returns may be higher than simply holding the stock if BHGE stays below $22.05 through Sep 20, 2019. The covered call strategy offers limited protection if the stock drops in price, but if the stock goes below $20.06 expect losses.

CHART: the RSI is below 30. It could either mean that the stock is in a lasting downtrend or just oversold and therefore bound to retrace (look for bullish divergence in this case). The MACD is below its signal line and negative. The configuration is negative. Moreover, the share stands below its 20 and 50 day MA (respectively at 23.89 and 23.99). Finally, Baker Hughes a GE Company is trading below its lower daily Bollinger band (standing at 21.76) so expect a rebound. Baker Hughes a GE Company is currently trading near its 52 week low at 20.09 reached on 26/12/18.

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What Option Open Interest Means to the Trader

Option open interest is the number of options contracts open in a specific option series.  Open interest serves as a measure of option liquidity in the underlying option series.  The higher the open interest, the tighter the bid/ask spreads will be so slippage in trades will be lower.  When looking at option series, you want to be sure open interest is at least 5,000 and that the bid/ask spreads are no larger than 20 point apart.

When net buying or selling occurs in the underlying security, the open interest will show this change in the same direction of trader moves.  Increases in call open interest indicate the underlying is advancing up while increases in put open interest indicate more selling pressure.

Here are some rules on how to interpret open interest levels for OTM calls and puts in relation to the stock’s price movement:

  • Growing OI in Calls – confirms strength of stock’s advance
  • Declining OI in Calls – bearish divergence of stock’s advance
  • Flat OI in Calls – slightly bearish as no additional support for stock advance
  • Growing OI in Puts – confirmation of stock’s decline
  • Declining OI in Puts – slightly bullish as no additional support for stock decline
  • Flat OI in Puts – slightly bullish as it is not confirming decline

The growing interest in OTM and ATM options will confirm the stocks continued movement in the same direction.  Basically, this means the traders who have
been right are still buying more options for continuing the same direction.  In comparison, when open interest falls it indicates that traders are leaving the trade so it will likely end the current movement.  Traders are taking their money off the table.

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