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. 

Recommended Articles

5 Franchises You Can Buy for Less Than $80K

A convenient way to start a business is through a franchise. There is an already built-in business model, consumer base, and operational supply chain. However, if you join a globally-known

How to Encourage Loved Ones to Adopt Healthy Eating

It’s painful to watch loved ones suffering with chronic health problems, such as food intolerances, headaches, allergies, digestive pain and menstrual issues. We wish there was something we could do

How to Retire 15 Years from Today

Retirement planning should ideally begin from the day you have your first job. However, even if you have made no special financial preparations for your retirement, you could still start

The Cost of Owning a Pet Can Be Surprising, So Plan Ahead

A cat or dog can be cute, cuddly, and great for companionship. Yet the cost of owning a pet can be surprising. Pets are living beings that must be taken

Dump Growth Stocks for Value? Market Weighing Options

In this article I make a brief comparison of growth stocks versus value stocks, a topic often addressed by the mainstream financial media.Growth stocks typically offer a substantially higher growth

7 Countries Where You’ll Find Bugs On the Menu

Creepy, crawly, gross, slimy. There are several ways to describe bugs, but here in the United States, few of us would use the words “delicious” or “yummy” when talking about

Get Rich Slowly with a Slick Dividend Reinvestment Strategy

The time-tested wisdom from leading value investors has always been that if you want to make money in the stock market, invest in high quality stocks and do not sell

A Surprising Way to Get Health Benefits from Coffee

You may have heard of green coffee bean extract for weight loss, but this potent natural remedy offers other important benefits, too. Read on to discover how green coffee bean

4 Ways to Make Extra Cash Using Your Car

Owning a car does not necessarily have to be an expensive proposition. While you cannot avoid paying the auto loan installments or the car insurance and maintenance costs, you can

Paid Not to Work: How Universal Basic Income Might Compensate for Coming Job Losses

The unemployment rate for the United States represents only the amount of people who are unemployed and also actively looking for work. Separately, the workforce participation rate includes Americans were unemployed

Meet the People Who Built or Inherited Fortunes — Then Lost It All

It’s amazing how much money rules our lives. The average person will barely make $1 million over the course of a working lifetime. Meanwhile, in the United States and all

Luxury Used Cars You Can Buy Cheap and Almost New

Looking for a luxury used car you can buy cheap? Careful what you wish for. First-time owners of luxury vehicles don’t always appreciate maintenance and repair costs. Uninformed buyers may