Opening and Closing Option Trades
Every option trade you make must specify the four terms: striking price, expiration month, call or put, and the underlying stock.
If any of these terms changes, that means that an entirely different option is involved.
Whenever you have opened an option by buying or selling, the status is called an open position.
As soon as the open position is offset by a closing transaction, it becomes a closed position. When you buy, it is described as an opening purchase transaction. And if you start out by selling an option, that is called an opening sale transaction.
ExampleOpen and Close: You bought a call two months ago.
Possible Outcomes of Closing Options
When you entered your order, it was an opening purchase transaction. That status remains the same as long as you take no further action.
The position will be closed when you enter a closing sale transaction to sell the call; you may also exercise the option; if you do not take either of these actions, the option will expire.
ExampleThe Risk of Exercise: You sold a call last month, placing yourself in a short position. As long as you take no further action, the position remains open.
You can choose to wait out the expiration period; or you may execute a closing purchase transaction, and cancel the option before expiration. As long as the short position remains open, it is also possible that the call will be exercised and you will have 100 shares called away at the striking price. Exercise will occur only if the stock's market price moves higher than the call's striking price.
Possible Outcomes of Closing OptionsEvery option will be canceled by an offsetting closing transaction, by exercise, or by expiration.
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Results for the Buyer
- If you cancel your open long position with a closing sale transaction, you will receive payment.
If the closing price is higher than the original purchase amount, you realize a profit; if lower, you suffer a loss.
- If you exercise the option, you will receive 100 shares (if a call) or sell 100 shares (if a put) at the striking price. You will exercise only when that action is advantageous based on current market value of the underlying stock.
To justify exercise, market value has to be higher than the striking price (of a call) or lower than the striking price (of a put). At that time, you will be required to pay the striking price plus trading fees, acquiring stock below current market value.
- If you allow the option to expire, you will lose the entire amount of premium paid at the time of purchase.
It will be a complete loss.
Results for the Seller
- If you cancel your open position with a closing purchase transaction, you pay the premium. If the price you pay to close is lower than the amount you received when you opened the position, you realize a profit; if it is higher, you suffer a loss.
- If your option is exercised by the buyer, you are required to deliver 100 shares of the underlying stock at the specified striking price (of a call) or to purchase 100 shares of stock at the specified striking price (of a put).
As a call seller, exercise results in shares being called away. As a put seller, exercise results in shares being put to you.
In either case, upon exercise, the premium you originally received for going short is yours to keep, and that adjusts your net cost.
- If the option expires worthless, you earn a profit. Your open position is canceled by expiration, and the premium you received at the time that you sold the option is yours to keep.
These outcomes are summarized in Figure .
Notice that buyers and sellers have opposite results for each outcome upon close.
The investor who opened the position through buying receives payment upon sale; and the investor who opened the position through selling makes payment upon a later purchase. The buyer elects to exercise, whereas the seller has no choice as to the decision, nor over the timing of exercise. If the option expires worthless, the buyer suffers a total loss, and the seller realizes a total profit.
[caption id="attachment_12440" align="aligncenter" width="460"] Outcomes of closing the position.[/caption]
Smart Investor TipAnalysis of the possible outcomes is the key to identifying opportunities in the options market.
Risk and opportunity evaluation is imperative.
Successful options traders need to be shrewd analysts.
By Michael C. Thomsett
Copyrighted 2020. Content published with author's permission.