You may have heard it before. When you buy an options contract, you obtain the right to buy (for calls) or sell (for puts) shares of stocks before a predetermined period.
You are not required to buy or sell, however. The price that you buy and sell is known as the strike price. The predetermined period is called the expiration date. For this right, options buyers pay options sellers a premium.
The premium represents the market price of the contracts. Each option contract has an associated premium. These premiums change with every change in the underlying stock price.
The fact that the premiums change implies that the options contracts themselves are tradeable. For experienced traders, this is an obvious feature.
Many beginning options investors, however, are not aware of this. It is not often covered in articles or texts on the subject.
Why tradeable options matters
You may be wondering why it matters that options are tradeable. The main reason is that it provides flexibility.
Suppose you bought a call. You decide that if the price of a stock reaches a certain level, you will exercise the call.
Exercise means that you will buy shares of the stock as part of the option agreement. The price you pay is the strike price determined at the time you bought the contract.
To realize the profit, you probably want to sell the shares immediately. However, this practice is not permitted due to trade settlement rules.
When you purchase a stock, you have three trading days to put enough cash in your account to cover the purchase. If you trade on margin, you can use one-half of the cost as margin, but you will need to settle in three days for the other half.
If you were to sell your shares immediately, your broker would penalize you for what is known as free riding. This practice can cause brokers to freeze your account for 90 days for the first offense and may even lead to a ban on your account for future offenses.
If you have enough cash in your account when exercising, you won’t trigger a free riding violation. You could then sell the stock immediately for a profit.
At that point, though, you would need to wait three days to make further trades, unless you have enough cash to cover the new trades.
Most retail investors don’t have enough money to cover the settlement immediately. Therefore, they have three days to fund the trade.
After the three trading days pass and your account is settled, you are free to sell your shares. However, price fluctuations may adversely affect your position. If the price of the underlying stock decreases, your profit potential is less.
The best way to circumvent this problem is to close out your options contract for a profit. If the stock increased enough where exercising would be profitable (assuming brokers allowed freeriding, which they don’t), the option contract you are holding will have gone up in value. It would increase by the intrinsic value or more, depending on the situation.
Suppose you bought a call option with a six-month expiration. The current price of the underlying stock is $25. You purchase an at-the-money call ($25 in this example) for $2.00.
After six months, the price of the stock rose to $40. The intrinsic value of the option is $15. The option price that you are holding must be worth at least $15. You can sell your option without exercising for $15 or more.
Hedging
American options allow for early exercise. However, other regions, such as in Europe, do not. In these other regions, you can only exercise your options on the expiration date. You are free to close out your position to recognize gains at any point before expiration.
Having the ability to close out contracts is crucial for hedging strategies. Investors who buy puts may not wish to wait until the expiration date to realize the gains in their hedge.
If exercise were the only choice available, hedging on European stocks would not be a viable strategy.
