Yes, Options Contracts Are Tradeable. Here’s Why That Matters.

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. 

Investing 101: Do Bonds Belong in Your Portfolio?

Portfolio diversification is a strategy that helps investors manage risk. Investors often choose to diversify among industries for stocks, for instance. But they also consider diversification within different assets types.

Should You Use Extra Cash to Invest or Pay Off Debt?

Deciding between repaying debt repaying versus investing may seem impossible. Everyone’s financial situation is different and only you know from an emotional standpoint what might work best. Start with your

6 Healthy Morning Rituals That Make the Most of Your Day

Whether you are a “morning person” or not, how much thought do you give to the start of your day? Do you realize that by adopting a few simple morning

How to Read and Understand an Options Quote

When you begin trading options you'll spend part of your research scanning for the right options to buy. When you find a list of options, then you'll need to learn

Test Your Financial Advisor’s Loyalty with These Simple Questions

You have a financial advisor in order to make certain you have budgeted your money correctly, have planned for future financial needs, and, in some cases, to turn some of

Sell Puts the Smart Way: Get Out Before Expiration Nears

Selling put options can be a great way to help increase the value of your portfolio without taking on too much risk. At its core, a put sale allows investors

refinancing

4 Pros and 1 Con of Refinancing Your Home

Two years ago the 30-year fixed mortgage rate was 4.6%. Today it is 2.9%. If your mortgage is in the high threes, you should consider refinancing. Refinancing would lower your

Easy Finance Tip: How to Calculate Your Net Worth

To calculate your net worth, just subtract your liabilities (what you owe) from your assets (what you own). While the equation is simple, it's important to get a snapshot of

Just a Few Bad Market Years Can Slam Your Retirement: How to Cut Your Risk

I believe one very underappreciated risk for investors preparing for retirement is the concept of “sequence of returns.” Sequence of return risk is the danger that the timing of withdrawals

Tai Chi Can Benefits for Those with Chronic Diseases

The Chinese martial art of tai chi can be beneficial to people suffering with chronic illnesses, according to research in the British Journal of Sports Medicine (2015), conducted by Dr.

Two Measures of Options Volatility That Matter

Most people often have a notion of what volatility means. They understand, at least conceptually, that it has to do with data of situations that vary over time. Weather is

3 Financial Habits to Adopt Before You Retire

Nobody wants to work until the day they die. We all want to get to a point where we can simply sit down, relax, and enjoy life.  Consider adopting these