Investing in options is presumed to be more difficult than investing in stocks. So is changing your oil for the first time. But in both cases, once you’ve done it a couple of times, it’s no longer daunting.
However, unlike investing in stocks, options investing has a unique set of rules.
The first – and one of the most quoted – rules when it comes to buying options, whether they be puts or calls, is that you have the “right but not the obligation” to buy or sell the underlying stock at the strike price.
That is mostly true except for on one occasion: When options expire, they expire either “in the money” or “out of the money.”
For example, if you own the right to buy AT&T (NYSE: T) at $30 and the shares close at $29.99, your option will expire worthless and you don’t have to do a thing. Your obligation is over.
But if AT&T closes at $30.01 at expiration and the options you own are still in your account (meaning you didn’t sell them prior to expiration), you’re in for a surprise. That surprise could be pleasant or unpleasant depending on what your objective is.
If your objective was never to own AT&T, you’re in for a shock. If the option closes in the money (the share price is above the strike price at the close), then you will be assigned the corresponding number of shares for which you are holding options. So if you held 10 contracts, you would be assigned 1,000 shares.
Come Saturday morning after expiration, you would see those 1,000 shares of AT&T in your account – along with $30,000 (1,000 times $30) less cash. If you didn’t have the cash in your account, you would face three choices. Send the $30,000 in immediately, sell the shares at the open on Monday morning, or have your broker sell stock in your account to fund the purchase.
Just so you know, a couple of days before, your broker should send you an email or other message alerting you to the possibility of such a scenario. Make sure you take the call or look at the email.
For most people, this isn’t an issue since they monitor their accounts regularly and are aware of their positions. But there are occasions, especially in a volatile market, for all sorts of things to happen at the last minute.
The solution is to always check your account at 3:30 p.m. on the day of expiration if you trade options.
The second important rule of options trading is for put sellers like me. When you sell puts, you are obligating yourself to buy the shares of the underlying stock anytime at or before expiration if you can buy the shares at the strike price. If the shares are trading above the strike price, that isn’t going to happen because you could immediately sell the shares in the market and pocket a profit.
However – and this normally occurs at expiration or a few days before – if the stock is trading below your strike price, you will be assigned the shares and must have the money to pay for them.
The only way out is to buy back the options that you sold if you don’t want to have that obligation anymore.
Again, it’s up to you to know the type of options strategy that you are using. The broker cares only that you pay for it.