The Truth About Option Obligations
A Note From Karim: Over the past several weeks, I’ve outlined the ins and outs of an income strategy that scares many investors… trading options.
The truth is, if you’re avoiding options, you’re missing out on one of the best passive income plays I’ve seen in my 20 years in the industry.
All you need to master options are the basics.
To check out my archive of educational articles on options, click here.
There’s a reason why the actual option you trade is called a contract…
And it’s not because each option contract is equal to controlling 100 shares of stock.
It’s called a contract because that is what you have entered into. Any time you buy or sell an option, you are entering into a contract to do something. The difference in buying and selling lies with obligation to perform and liability. In some cases, your liability can be limited, and in other cases, it can be unlimited.
The most common option trade is the straight long option trade. This means you are buying an option. It can be an option that bets on the upward (call) or downward (put) direction of the underlying shares. (For more on the most common types of options trades, see my last article.)
When you buy the option as a long position, you are entering into a contract that gives you the right, but not the obligation, to do something.
When you buy a put or a call option, you have the right to act, but you are not obliged to do so. But that does not relieve you of all responsibility to act.
If the option is out of the money – meaning that the shares are lower than the strike price – then the option will expire worthless.
There is an occasion when this is not the case… when the option is in the money. In the money means that the stock is trading above your strike price… and you are “in the money”!
(If the option is in the money, you may automatically be forced to buy the shares at expiration if you haven’t sold the option prior to it expiring. In reality, it doesn’t really matter – because if you are in the money, you are up on the option and the shares. The vast majority of people will sell the option before expiration and take the gains.)
An Important Distinction
In options trading, there is distinction between selling an option you haven’t initially bought and selling an option you have already bought.
The nature of the contract changes dramatically when you sell an option that you don’t already own, or “go short.”
This means you are obligated to replace that option by buying it back at some point or execute the terms of the underlying obligation.
This sounds complicated, but think of it like this: When you are long an option, you have a right but not an obligation. When you are short an option, you have an obligation.
Two of the most common trades where you are obligated are covered calls and put selling. When you sell an option against shares that you own (covered), you are obligated to sell those shares if the shares trade at or above the option strike price.
The only way to remove that obligation is to reverse the trade and buy back the option you sold. The fact that you have to act makes it different than being long with the right but not the obligation.
In put selling, you are obligated to buy the shares of the stock you sold puts on – if the shares close at or below the strike price before expiration. Again, you have an obligation to do something unless you reverse the trade.
In the case of put selling and covered call writing, which are pretty similar strategies, your obligation applies only when certain conditions are met. However, in both cases, those obligations can be forced upon you prior to expiration as well.
Comedian Ron White once said “you can’t fix stupid.” There are also contracts that expose you to unlimited risk. If you enter into an option trade such as selling naked calls, your risk is undefined. When you do that, you are placing a bet that shares will not go higher than a certain price.
Any amount higher than that price means you are exposed for the difference. For example, cancer cure stock X is trading at $2, and you sold the $5 calls. This means that if the shares close at $5 or lower at expiration, you get to keep the premium from selling the calls.
Two days before expiration, the company announces a cure for cancer. The stock shoots up to $100 the next morning and continues higher. You’re on the hook for at least a $95 loss – it’s that simple.
If you see the words “undefined risk” anywhere, run.