How to enter speculative and cash flow strategies

So far, we’ve described the potential of options to profit from expected directional market moves. Initiating these orders involves a “buy to open” order with the broker. Yet option strategies exist which are initiated with a “sell to open” order with the broker.

The two types of ways to initiate option orders and the two types of options themselves can be combined in creative ways to provide a great deal of flexibility for the option trader.

There are a number of predefined option strategies that can be employed to profit from market moves. In general, these strategies can be categorized as either speculative or cash-flow generating.

Those who speculate on market moves simply initiate a “buy to open” order with their broker using either a call or put, depending on the expected direction.  Because options are leveraged trading instruments and cost a fraction of the stock itself, any move in the stock creates a much higher percentage gain in the option. 

The cash flow generating option strategies are initiated with a “sell to open” order. 

Those who sell option contracts  believe the stock won’t move as far or as fast as the contract buyer thinks. In exchange for obligating themselves to the terms of the option they sold, they get to keep the premium paid by the buyer of that option.  In the next lesson, we’ll look at option strategies from both the point of view of buying and selling option contracts.

Trading Options

Option market makers list their available options and brokers collect this data to present the option chains you see when you want to place an order. 

If you’ve seen this kind of data table before, you know that option chains are sorted by option type, expiration date, and strike price. Each of the options in these tables has a bid price and an ask price. 

The ask price is what buyers pay in premium to acquire the option and the bid price is the premium that is paid to the seller of that contract. While the market is open and stock prices fluctuate, these prices constantly change. 

The difference between the bid and ask price is called, wait for it…the bid-ask spread.

What the bid-ask spread might lack in a creative name, it makes up for in importance.

All option contracts are offered by market makers. Market makers will usually create as many new contracts as necessary to satisfy demand, so long as they can absorb the risk that comes with doing so. The easiest mechanism they have for doing so is the size of the bid-ask spread.

The daily count of contracts traded is what constitutes trading volume for the option, and the number of contracts which haven’t been exercised is known as open interest. If trading volume and open interest are low, the professional option sellers (the market makers) will widen the distance between the best bid and ask prices they offer. That allows them to make just a bit more money on each trade, so they can absorb the risk of losses.

That’s how you know immediately that the options are not highly liquid–because the bid-ask spread is wider than usual. This implies that option sellers insist that the trader needs to pay more money to make the trade. 

You can see for yourself that buying an option will create an immediate loss–because of the bid-ask spread. And if that spread is wider, the cost to make the trade is higher. So how does an option trade make money?

For a call or put option to become profitable, the price of its underlying stock needs to move. 

The three criteria for that movement are:

1. It needs to be in the right direction (up for calls, down for puts). 
2. It needs to be a big enough move–that usually means and above average price change. 
3. The stock needs to make this move relatively quickly.

Options are priced to account for average moves over a typical period of time, and sometimes even a bit more than that. 

That’s why, in order for options to profit, the underlying stock has to make a move with enough magnitude to overcome both the bid-ask spread and the full price of the option. It’s not easy to do. That’s why our experts, and their research teams, spend the time and effort that they do, to help you identify those times when stocks might make unusual moves large enough to overcome the cost of the option contracts.

One technique options traders commonly use to reduce the cost of the spread is to use limit orders. They will try to work with their orders to place them inside the spread. This can potentially get them a trade execution with more favorable prices than the currently published Bid or Ask prices listed in the options chain.

Now we’ve covered a lot in this lesson, so in the next few lessons we will take a closer look at each of the four basic options transactions, to see how option traders can best tackle the challenges of each one.

Assignment Risk

Option buyers pay a premium for the right to buy shares at the strike price anytime during the life of the contract. Most option buyers don’t exercise this right, preferring to sell back their option contract as a less expensive and easier way to capture profits.

Option assignment is the term used to describe buyers exercising their contractual rights and sellers being forced to fulfill their contractual obligations.

There are three levels of Option Assignment Risk:

1. Extremely low: Out of the money option prior to expiration.
2. Low: In the money option prior to expiration.
3. Guaranteed: In the money option upon expiration.

There are two specific instances when option buyers may choose to exercise their rights prior to expiration which are then assigned using a lottery system: If selected, the option seller must sell them their shares.

The first is during times of high volatility, when brokers may artificially limit the number of shares available for purchase. In this instance, an option buyer may choose to buy an option and then immediately exercise it to get the shares.

The second is on stocks with limited option open interest. If open interest is less than 100 and an option buyer decides to exercise their right to buy shares, the option seller is likely to have their stock called away early.

Remember, option sellers receive a premium for obligating themselves to sell their shares at the strike price of the contract. The only way an option seller can remove this obligation is to buy the contract back, which can be done anytime until expiration.

Option buyers and sellers neither know, nor care, who is on the other side of their trade. In fact, an option buyer may buy an option from someone and sell it back to someone else.

It’s up to the market maker to match buyers and sellers for each stock option, at each strike price, and at each expiration. If they can’t find someone else, they become the other side of the trade.

Because the risk of early assignment is so uncommon, many option sellers don’t fully realize that it is continuous. In other words, it’s possible that a buyer of an option may choose to exercise their option before expiration, and if chosen, the option seller would then be obligated to sell their shares at the strike price they agreed to.

Why a buyer may want to exercise their option prior to expiration has to do with the way options are priced. Our next lesson will discuss how options prices change.