There are two types of settlement: physical and cash.

 

The settlement process in an option contract depends on whether you own an American or European-style option contract. Before we talk about the specific mechanisms of these contracts, we need to clarify the two types of options contracts.

 

The Difference Between American and European Options

There are two styles of options in exchange-traded markets: European and American. Two fundamental properties distinguish the two:

 

• The settlement style (cash-settled or physical settlement)
   
• When the contracts can be exercised

 

What is an American Option Contract?

American option contracts have two unique properties when compared to European options:

 

• American options use physical settlement
   
• American options can be exercised at any time until the expiration date

 

What are European Options?

European options have two unique properties when compared to American options:

 

●     European options use cash settlement
 

●     European options can only be exercised at expiration
 

What is Physical Settlement in Options Trading?

A physically settled options contract settles for actual ownership of the underlying asset. For example, when you buy a call option on a stock like Apple or Microsoft, you will receive shares of the underlying stock should your call be in-the-money at expiration.

 

The catch here is that only American-style options contracts settle physically.

 

Nowadays, the only liquid options contracts that physically settle are options on US equities, as settling something like a wheat or crude oil contract would be far too cumbersome for most traders, given the burden of transporting and delivering potentially thousands of pounds of goods.

 

It’s critical to be aware of this crucial distinction when trading American-style options, as not knowing it can lead to some hiccups. For instance, if you own an American-style call option on, say, AAPL, and it’s in the money at expiration, you’ll be required to “take delivery” of those Apple shares.

 

Taking delivery, in this instance, would require you to buy the shares. So if you own a 120 AAPL call and AAPL is at 130 at expiration, you’d be required to buy 100 shares of AAPL at $120. Of course, because AAPL is trading at 130 in this scenario, you can turn around and sell them for a $10/share profit, but there’s an asterisk there.

 

Your broker has discretion if you need the margin in your account to support the purchase (or sale) to fulfill the assignment at the expiration time. They can fulfill the assignment (usually charging you a fee), then give you an immediate margin call, allowing them to sell your securities using a market order to fulfill the margin call. This can lead to a scenario where your deposits are sold out from under you to satisfy a margin call.

 

The situation gets direr because options assignment takes place after the market closes, meaning the bid and asks are typically super wide, especially for less liquid stocks. And they’ll also charge you a fee when they have to trade your account on your behalf in case of a margin call.

 

However, all of this is very avoidable. All you have to do is ensure you close your options positions before their expiration date. That can even mean minutes before the market closes on the expiration day. So long as you’re out of the position, you don’t have to deal with any of the politics of settlement, assignment, or expiration.

 

Early Assignment in Physically Settled Options

American-style options can be exercised at any time before the expiration date, in contrast to European options, which can only be settled at the expiration date.

 

As a result, American-style options are sometimes exercised early, in which the physical settlement begins immediately. While this is rare, it is likely to happen to an options trader at some point in their career and knowing how the process works beforehand is critical to reacting correctly.

 

The first thing to get straight is how option exercising works. Only the owner (holder) of an option can initiate an early exercise. This means that if you only buy puts and calls, you never have to worry about this being sprung on you.

 

However, as an active options trader, you’re likely utilizing several spread strategies involving buying and selling (shorting) options. In this case, there’s a remote chance you’ll face an early assignment.

 

Let’s look at an example to simplify things. If you receive an early assignment, you must deliver on half of the transaction. You’re short one 120 AAPL call that expires in 12 days. The holder of this option decides to exercise the option, and now the settlement process begins. AAPL is currently trading at 170.

 

At this point, you’re obligated to deliver 100 shares of AAPL at $120 per share. If you own the shares of AAPL, this is easy, your broker will transfer your shares of AAPL, and you’ll receive $120 per share.

 

However, if you don’t own the shares, you must purchase them in the open market for $170 per share and immediately deliver them to the holder, receiving $120/per share. You’d immediately realize a $50/share loss in this case.

 

If you don’t have the capital to fulfill this obligation, your broker will perform it on your behalf and give you a margin call.

 

So as you can see, getting an early assignment is never fun. But you’re in luck because it could be better for option holders to exercise their options early. In most cases, it makes far more sense for the holders to sell the opportunities in the options market, as exercising early means you lose out on any extrinsic value in the options market.

 

In other words, exercising options early almost always loses you money. But there is one situation where the risk of early assignment increases considerably: when the option is deep in the capital, and the ex-dividend date is near the expiration date.

 

This is because deep-in-the-money options have very little if any, extrinsic value as it is. So exercising early costs the holder little, but it allows them to capture the dividend.
 

How To Avoid Early Assignment

The best way to avoid early assignments is never to sell deep-in-the-money options. This is easy, as it rarely makes sense to do this as it is because, as an options seller, you’re looking for options with high extrinsic value–this is the premium you collect as a seller. If there’s no extrinsic value, you give someone free optionality.

 

Outside of some very specific edge-case, options traders don’t sell deep ITM options, so you don’t have to worry about missing out on anything. There’s rarely a case where it makes sense.

 

What is Cash Settlement in Options Trading?

Cash-settled options pay out the cash value of your choice at expiration instead of delivering shares or a physical commodity. Most exchange-traded opportunities are settled physically nowadays, as the burden of physical delivery, for, say, the S&P 500 index, would be too cumbersome, as it’d involve delivering the correct ratio of 500 different shares of stock. That burden multiplies when it comes to physical commodities like oil.

 

The only liquid options that still settle physically are US equity options, as delivering shares is relatively simple, as it’s just ones and zeros on a computer.

 

Let’s look at an example. You own one SPX (S&P 500 index) call at 3600. The index settles at 3650 at expiration. You’d receive $5,000 in cash at expiration, making your profit $5,000 minus the premium you paid for the option.

 

The proliferation of cash settlement in options trading has enabled the options market to become far more liquid and available to traders, speculators, and hedgers.

 

We have the primary difference between American and European options: their distinct settlement rules.
 

Related articles

• How Index Options Settlement Works
• Can Options Assignment Cause Margin Call?
• Assignment Risks To Avoid
• The Right To Exercise An Option?
• Options Expiration: 6 Things To Know
• Early Exercise: Call Options
• Expiration Surprises To Avoid
• Assignment And Exercise: The Mental Block
• Should You Close Short Options On Expiration Friday?
• Fear Of Options Assignment
• Day Before Expiration Trading
• Accurate Expiration Counting
• Expiration Short Strategies

This dynamic nature of options allows you to craft a position to fit your exact market view. Perhaps there’s a big Federal Reserve meeting coming up and you expect the market to overreact, but you don’t have a specific view as to which direction. In this case, you can use a market-neutral option spread like a straddle or strangle.

 

In the same vein, if the financial media and traders are making a big stink about something you deem a nothingburger, you can use strangles or straddles to take the view that the market will underreact to the news compared to what the market pricing expects.

 

Strangles and straddles are market-neutral options spreads which are apathetic to the direction that price moves. They instead allow a trader to express a view on the magnitude of the price move, regardless if the price moves up or down.

 

Let’s paint a quick hypothetical for demonstration.

 

There’s a Federal Reserve meeting in a week. There’s tons of talk about the possibility of a Fed pivot and the dramatic implications that’d have for the global economy. Looking at the S&P 500 options for that expiration, you see that the implied volatility is very high compared to past Fed meetings. Traders are expecting the Fed to drop a surprise in some sense.

 

Based on your own macro view, you’re unconvinced. You believe the Fed will continue their campaign of modest hikes of rates through the first half the year. In other words, you expect business as usual while the market expects radical change.

 

As an options trader, you’re fully aware that change equals volatility and the lack of change leads volatility to contract, making most options expire worthless. You decide to sell a straddle, which involves selling an at-the-money put and an at-the-money call simultaneously. Should your view pan out, you’ll be able to pocket a good portion of the premium you collected when you opened the trade.

 

What Is a Strangle?

A strangle is market-neutral options spread that involves the simultaneous purchase or sale of an out-of-the-money call and an out-of-the-money put. So if the underlying is trading at $20.00, you might buy the $18 strike put and the $22 strike call.

 

In this case, you’re hoping for a large price move in either direction, as your break-even price is often pretty far from the current underlying price.

 

Let’s look at a brief example of a long strangle in $SPY using a .30 delta put and call with 27 days to expiration. Here’s the options we’re buying:

 

●     SPY (underlying) price: 396.00

●     1 386 FEB 27 PUT @ 4.31 (-0.30 delta)

●     1 407 FEB 27 CALL @ 3.54  (0.30 delta)

●     Cost of Position: 7.85

 

Here’s the payoff diagram of this position:

 

Once the position gets outside of the shaded gray area, the position is in-the-money. To provide some context to this position, SPY must move up or down roughly 4.5% for your position to be in-the-money.

 

Let’s look at the same trade but from the short side:

The details of this trade are a mirror opposite of the previous example. You’d collect a $7.85 credit, and your break-even levels are outside of the shaded gray area. You’d make this trade if you expect SPY to remain within that range through expiration (27 days).

 

Strangle Strike Selection

Strike selection is a significant factor here and there’s no correct answer really.

 

The lower delta options you choose, the cheaper the spread and the lower the probability of profit will be. Perhaps you have a very specific market view, making strike selection obvious. But in most cases, novice option traders choose arbitrary strikes, which is a mistake. Strike selection is one of the most important aspects of trade structuring.

 

An easy way to start being more thoughtful about selecting strikes is to view an option’s delta as a rough approximation of the probability of expiring in-the-money. This simple trick provides a lot of context to option pricing.

 

You’ll see at-the-money options often hover around .50 delta, because the market basically has a 50/50 chance of going up or down over any time period not measured in years. As you get further from the money, deltas go down, which also makes intuitive sense.

 

Using this framework, you can look at a .20 delta strangle and think “the market thinks there’s a 20% chance of either of these options expiring in-the-money. Is my probability forecast higher or lower than that? If you can answer this question, your strike selection becomes not only easier, but far more thoughtful.

 

What is a Straddle?

A straddle is a market-neutral options spread involving the simultaneous purchase (or sale) of a call and put at the same strike price and expiration. The goal of the trade is to make a bet on volatility in a market-neutral fashion.

 

While any trade trade involving buying or selling a put and a call at the same strike price and expiration is technically a straddle, the majority of the time when we talk about straddles, we’re talking about an at-the-money straddle, meaning you buy a put and call at the ATM strike.

 

In other words, if implied volatility is 20%, but you expect future realized volatility to be much higher than that, buying a straddle would provide a profit regardless of which direction the  market goes, or how it arrives there.

 

Along similar lines, if you expect realized volatility to be far less than 20%, you can short a straddle to profit from the market’s overestimation of volatility.

 

In a word, you want to buy a long straddle when you think options are too cheap, and short straddles or short strangles when options seem too expensive.

 

Here’s an example of a long straddle in SPY with 27 days to expiration. With SPY trading at 396 at the time of writing, we’d want to buy the 396 call and puts. Here’s how that’d look:

 

●     SPY (underlying) at 396.00

●     1 396 FEB 27 CALL @ 8.59

●     1 396 FEB 27 CALL @ 7.69

●     Total cost of trade: $16.28

 

As you can see, this ATM straddle costs more than double what our 0.30 delta strangle costs us. Being wrong on straddles is far more painful. But this payoff diagram shows us the upside to this trade-off:

 

What is most interesting here is that our 0.30 delta strangle from the previous example has nearly identical break-even points to this ATM straddle: around 379 and 414. However, looking at the shape of the P&L, you can see that you only experience your max P&L loss if the market goes absolutely nowhere and is still at 396 at expiration.

 

If the market moves even modestly in either direction, your trade begins to move in your favor. This is in stark contrast to our strangle, in which we experience maximum loss at a far wider range of prices.

 

So while you do have to shell out more premium to establish a straddle, it’s quite unlikely you’ll actually lose all of your premium.

 

The Similarities Between a Strangle and a Straddle

1. Both are Defined-Risk Options Spreads

   Both the straddle and strangle involve buying two different options without selling any options to offset the premium paid. So the most you can lose in either a straddle or strangle is the premium you paid.

   A defining trait of many defined-risk, long options strategies is the convexity afforded to you; you know the maximum you can lose is X, but your upside is theoretically unlimited. This can of course lead to occasional massive wins where the market basically trends in your direction until expiration.
    

2. Both Are Market-Neutral

   Options allow you to express a more diverse array of market views than simply long or short. One of those is the ability to profit without having to predict the direction of price.

   While market-neutral is an easy term to use because most understand it off the bat, that’s not entirely correct. You can more accurately call straddles or strangles delta neutral strategy because while you’re neutral on the direction of price, you’re still ultimately taking some sort of market view.

   In the case of straddles and strangles, you’re taking a view on whether volatility will expand or contract. Or in other words, do you have conviction on whether the market will move more or less than the option market thinks? If so, you can profit from this view.

 

Put simply, if you expect the underlying to get more volatile before expiration, you want to be long volatility. Taking a long volatility view assumes that the options market’s implied volatility forecast is too low, making options too cheap.

 

Expressing a long volatility view in the context of a straddle or strangle means taking the long side of the trade (buying the options instead of shorting them).

 

Just as we described in the intro of this article, if you hold the view that the market is overhyping the significance of a catalyst, you make the same trade in reverse; you can short an at-the-money put and an ATM call, which is a short straddle. If realized volatility is lower than implied volatility, then you’ll end up pocketing a good portion of premium when you close the trade.

 

The Differences Between a Strangle and a Straddle

Straddles and strangles express very similar views; traders using them are either expressing a long or short volatility while remaining agnostic on price direction. Where they differ is the magnitude of their view, or how wrong they think the market pricing of implied volatility is.

 

From the long-volatility perspective, it’s cheaper to buy a strangle because you’re buying OTM options but the dilemma is that with cheaper OTM options, you have a lower probability of profiting from the trade. The market needs to move more to put you in the money.

 

If you flip this dilemma to the short side, you have the same problem. When shorting strangles, you have a high probability of collecting the entire premium at the conclusion of the trade, but when the market does make a big move, you experience a huge loss. So you can rack up several wins in a row only to see one loss knock out all of these gains.

 

ATM Straddles Have More Premium Than Strangles

At-the-money options have more premium than OTM options. So it follows that the straddle, a spread with two ATM options, would have far more premium than one with two OTM options, the strangle.

 

For this reason, systematic sellers of premium, what you might call the “Tastytrade crowd,” really like straddles for their high premium properties. This property of higher premium doesn’t make the straddle superior for premium sellers, as there’s no free lunch–premium sellers are paying for this higher level of premium with a lower win rate on their trades.

 

Straddles Have a Higher Probability of Profit

As it might’ve become clear throughout this article, constructing options spreads is all about tradeoffs. Want to put out a small amount of capital with the possibility of a huge win? You can do that, but you’ll hit on those trades a small portion of the time. Likewise, if you want to profit on most of your trades, you’re essentially paying for that in the sense that your frequent winners will be small profits and your infrequent losers will be much bigger.

 

This dynamic applies equally to the choice between straddles and strangles. A straddle requires more premium outlay with a higher possibility of profiting the trade, while strangles enable you to risk less overall on the trade, but you have to be “more right” on your market view to make a profit.

 

Your choice between these spreads when you want to make a market-neutral bet on volatility ultimately comes down to your own trading temperament, as well as which spread makes more sense given your market view.

 

Bottom Line: Straddles and Strangles Are About Volatility

For most traders, their introduction to options is related to an attraction to the leverage and convexity for their directional market bets. But as they peel the layers away and learn about the true nature of options, they learn that they’re far more than tools to get leveraged exposure to a stock or index.

 

The first and easiest lesson is the time aspect. The longer-dated the option, the more it costs. Optionality costs money. This is very easy to grasp. One-year options should cost more than one-day options.

 

The next step is understanding how market volatility relates to option pricing. It’s far less intuitive.

 

But, consider this hypothetical…

 

You’re offered the choice between paying the same price for a one-month at-the-money option on two different stocks.

 

One is highly volatile and frequently swings 10% daily. Tesla (TSLA) is a good example.

 

The second stock is a stable blue chip stock that doesn’t move around that much. Think something like Walmart (WMT) for instance.

 

Most would correctly choose the volatile stock. It’s common sense, right? After all, a stock like Tesla can move up or down 30% in a month, while a stock like Walmart often swings less than 10% in a month.

 

So like time, volatility has a price. But because future volatility is uncertain, that price is dynamic and subject to the opinion of the market. Like any market price, there are always opportunistic traders who profit from the inefficiencies of market pricing.

 

This is where volatility trading comes in. Think of strangles and straddles as the hammer and drill of volatility trading. They’re classic tools you reach for over and over again.

 

Remember, whenever you buy or sell an option, you’re making an implicit bet on volatility, whether you like it or not. If you buy an option, you’re taking the stance that volatility is too cheap.

Related articles

• How We Trade Straddle Option Strategy
• Exploiting Earnings Associated Rising Volatility
• Buying Premium Prior To Earnings – Does It Work?
• Can We Profit From Volatility Expansion Into Earnings?
• Long Straddle: A Guaranteed Win?
• Straddle, Strangle Or Reverse Iron Condor (RIC)?
• Selling Strangles Prior To Earnings
• Straddle Option Overview
• Long Straddle Through Earnings Backtest
• Straddles – Risks Determine When They Are Best Used
• Long And Short Straddles: Opposite Structures

An option’s terminal value is entirely reliant on the underlying stock’s price on the expiration date, making values far more calculable.

 

But crunching some numbers and coming up with a reasonable value for an option doesn’t mean you know how to trade them profitably. The secret sauce is using your understanding of options pricing to predict how it’ll change in the future.

 

Primarily, that understanding comes down to interpreting how the different pricing factors, known as option Greeks, will change with time. The most critical Greeks are Delta, Theta, Vega, and Gamma.

 

And gamma is the worst understood of the Greeks while also holding the potential to be their most influential.

 

What is Gamma?

Put simply, gamma measures how fast or slow the delta will change. Options with high gamma values will change far quicker than those with low gamma values.

 

In more technical terms, gamma is the rate of change of delta. Basically, if we have a call option with a delta of 0.20 and a gamma of 0.02, a $1 increase in the stock will increase delta by 0.02 to 0.22.

 

Being long gamma is the same as being long options, as all long option positions have positive gamma, while all short options positions have negative gamma.

 

If you’re looking to get on board for a trend in a stock, you want to be very long gamma. High gamma is like a snowball rolling down a hill when a stock is trending. As the stock continues to trend, long gamma positions benefit more and more the longer the trend lasts.

 

This works because as the stock goes up, high gamma pushes delta upwards, making each successive move more significant in terms of P&L.

 

Gamma’s Relationship With Time and Moneyness

As a rule, the closer an option’s strike price is to the at-the-money strike, the higher the gamma is. The further out-of-the-money, the lower its gamma.

 

Furthermore, gamma increases as the expiration date of an option approach. To understand this intuitively, take an option at expiration. It either has a delta of 1 (expired ITM) or 0 (expired OTM and thus worthless).

 

Now let’s rewind the clock by five minutes. The underlying is at 99.95, and we own the 100 call. This option’s fate will be decided in five minutes, resulting in a delta of either 1 or 0. For this reason, it makes sense for delta to move a lot with each price change when we’re so close to the money.

 

Gamma Risk: An Introduction

Understanding the unique exposure to each Greek pose is one of the building blocks of options trading. It allows you to be more thoughtful when constructing positions.

 

Think of gamma as a horsepower rating for an options position. The higher the gamma, the quicker the option price can change. A little pressure on the throttle of a Porsche 911 can still make a big move. Conversely, putting the pedal to the metal in a 1970s Honda barely gets you to highway speed.

 

To provide context, let’s look at two call options in the same stock: one with high and one with low gamma.

 

First, we have a 0.31 delta, 0.031 gamma TSLA 187.5 call trading at $2.14, expiring in one day. With spot TSLA trading at 183, let’s look at how quickly the value of this option can change.

 

 

Keep in mind that this is napkin math. Gamma doesn’t stay constant, nor are we accounting for theta decay or vega here. The point is to demonstrate how gamma can be like rocket fuel for an options position, good or bad. With each price increase, the ensuing price increase is more intense.

 

You’ll frequently hear the word “convexity” thrown around in options circles, which is essentially what they mean by that. As Simplify Asset Management puts it, convexity is when an investment payoff is curved upwards. See their graphic below:

 

 

You can think of gamma as the slope of the yellow curve. The higher the gamma, the steeper that curve will be.

 

The effect of this is that when you make a good call when you’re long gamma, your profits increase exponentially the more right you are. In other words, if you own the same Tesla call we referenced earlier, the P&L you make “per tick” increases with each successive tick until you’re in-the-money.

 

But just as you can be long gamma and benefit significantly from a runaway trend in a stock, you can also be short gamma.

 

And while it sounds lovely to be long gamma (it’s undoubtedly easier psychologically), there are some key benefits to being short gamma. Key among them is that you’re shorting options, and most options traders acknowledge that there’s an edge in being short options if you do it correctly.

 

Let’s return to the same Tesla call option example we just used, except this time, we decide to short the option, leaving us with the exact opposite position. So here’s where we’re at:

 

●     Delta: -0.31

●     Gamma: -0.031

●     $2.14 (net credit)

●     Expires in one day

 

Should we see the same scenario play out, where Tesla rallies aggressively, we’ll see the same phenomena occur. As this position goes against us, things just get worse and worse.

 

Bottom Line

We continue to hammer home the concept that trade-offs play such a massive role in options trading. Buying options gives us convexity with a defined risk, but we’re buying volatility which is overpriced on average, typically giving us a poor win rate.

 

Selling options typically gives us a steadier equity curve with more frequent wins, but we get bit in the rear end when an underlying begins to trend against our position, and short gamma quickly eats us alive.

 

As you develop as an options trader, you learn how each options Greek presents you with these sorts of complex trade-offs and how you can elegantly craft a position to fit your desired exposures very closely.

Related articles:

• Options Trading Greeks: Gamma For Speed
• Why You Should Not Ignore Negative Gamma
• Estimating Gamma For Calls Or Puts
• What Is Gamma Hedging And Why Is Everyone Talking About It?
• Short Gamma Vs. Long Gamma

 

 

Furthermore, combining multiple options and creating a spread enables traders to express a number of views that would be impossible using stocks or futures.

 

But the flexibility and dynamic nature of options bring with them some drawbacks.

 

Primarily, you can’t trade options in the same fashion as an S&P 500 futures contract. Whereas you can quickly trade in and out of several futures contracts in seconds due to their deep liquidity and narrow spreads, you can’t in the options market.
 

Options Are Illiquid

Upon opening an options chain for a highly liquid underlying like Apple or an S&P 500 ETF, you’re greeted with several different expirations, each sometimes containing dozens of contracts for different strike prices.

 

With over a hundred contracts existing for a given underlying at any time, you’d be correct in assuming that some are illiquid and thinly traded.

 

While the near-the-money strikes in the closest few expirations typically have adequate liquidity, it becomes a significant problem as you look further out-of-the-money or longer-dated options.

 

There are just too many options for them to have the liquidity of a stock or future.

 

Spreads Create Complications

When trading spreads, as most experienced traders do, you’re already doing something counterintuitive, trading multiple different securities simultaneously in one go.

 

Take a simple Bull Call Spread–we buy a .30 delta call and sell another .15 delta call to reduce the premium outlay.

 

Say we buy this spread for $1.75:

●     The .30 delta call costs $3.00

●     We collect $1.25 in premium for selling the .15 delta call.

 

The .30 delta call is closer to the money and hence is more liquid and will have narrower spreads compared to the .15 delta call. And because our .30 delta call has a higher gamma and delta, it will fluctuate more in price.

 

So if you want to exit the call spread, you might not be able to get an excellent price when you try to trade it as a spread. But if you’re “legging out” of the trade or closing out each contract individually, you’re forced to try to exit the illiquid option first, so you don’t get caught short an illiquid option after you sell the more liquid .30 delta option.
 

Wide Bid/Ask Spreads

As a result of the massive number of unique option contracts that exist at a given time, many of them are relatively illiquid, especially when compared to stocks and futures.

 

It’s common for an option to have a bid/ask spread that exceeds 10% of the total price. This is a remarkable contrast to a Dow 30 stock, which could cost $200 and have a spread of one penny.

 

As a result of these massive spreads, options traders need to “work” their orders more. They’ll often use the midpoint of the bid/ask spread as their reference price and try to get filled as close to the midpoint as possible. However, if you need to trade now and nobody will trade with you, traders are sometimes forced to take liquidity from the bid or offer.

 

So you can imagine that using a stop order, which triggers a transaction as soon as one price is touched, can result in unintentional bad fills.

 

A standard stop order becomes a market order once a given price is hit. If the spread is wide, you’re taking a massive haircut. The other option is, of course, using a stop-limit order. But we’re left with the same issue. Options are pretty illiquid, meaning your order might go unfilled, and the price might move away from your order before it gets filled.

 

Having a stop-limit order sitting in the market can give you a false sense of confidence, and feeling protected. However, if the order goes unfilled, the position can go significantly against you before you notice what occurred.

 

Options Positions Can Evolve in Unexpected Ways

We all understand that an option’s Greeks do a pretty good job explaining the factors affecting its value. However, the Options Greeks aren’t static. They evolve just as time, price, and volatility do.

 

As a result, you need to be an options veteran to have an intuitive understanding of how your options position will evolve given a drastic enough change in a given factor.

 

For example, if volatility just dramatically increased but only managed to whipsaw price, leaving it relatively unchanged, your new options position will behave differently moving forward. If you have a stop loss in the market, the stop loss might trigger due to the change in option characteristics, even if you still like the position.
 

Alternative to the Traditional Stop Loss

Using Price Alerts

If you use the underlying price to dictate your options trading, a potentially superior alternative to using pure stop losses is to set your discretionary stop losses using price alerts.

 

This involves setting price alerts for an underlying price that would drive you to trade and use the alert as a signal to start working an options order.

 

For instance, perhaps I own a few AAPL 142 calls, and I want to sell half of my position if AAPL hits 146. I can go into my charting software (TradingView) and set an alert for $146. As soon as the alert hits, I can start working a sell order for half of my calls, trying to get filled at the midpoint.

 

This approach gives you far more flexibility. Using the previous example, we might see that AAPL trades through $146 with considerable upside momentum. In this case, I may hold on for a bit longer until the market slows down to maximize profits. We would lose out on this opportunity if we had a stop loss in the market.

Using Stop-Limit Orders That Trigger Based on the Underlying Price

This approach allows us to combine the use of price alerts and the automatic nature of a stop order.

 

We set the price alert at our ideal exit price, but we also tell our trading platform to automatically send a limit order at a given reference price, like the midpoint of the bid/ask spread.

 

Instead of using the price of the actual option contract or spread to dictate where we exit the trade, it’s generally preferable to use the underlying stock price instead.

 

For instance, if we owned AAPL 142 calls, instead of setting an order to sell when the calls are trading at $1.00, it’s probably preferable to use something more concrete, like AAPL stock trading below 139.

 

So in English, “sell 3 of my AAPL 142 calls at the midpoint price if AAPL stock trades below 139.” This would require you to use a stop-limit order, which carries no guarantee of execution.

 

While most modern options trading platforms are capable of a simple conditional order that allows you to sell an option when an underlying reaches a certain price, some platforms might not let you to do this, potentially forcing you to adapt or switch brokers.
 

Bottom Line

Mechanically entering and exiting options trades is much more complex than stocks or futures. There are too many factors, namely wide bid/ask spreads, to consider.

 

As an options trader, it’s typically better to start slow. This often means focusing on the 15-45-day expirations reasonably close to the money. Enter trades that give you time to exit when you decide you’re right or wrong.

On the surface, index and stock options are very similar. Still, there are some differences that traders should be aware of. Understanding these differences can save you from making some costly mistakes in the future. An ounce of prevention is more valuable than a pound of cure.

 

In this article, we’ll look closely at the factors that make stock and index options unique.
 

What Are Stock Options?

The buyer of a stock option has the right, but not the obligation, to buy or sell shares of a specific stock at a predetermined price before the expiration date. Stock options are primarily used for either speculation, to bet on big price moves in a stock, or to hedge risks in a stock, like an upcoming earnings report.

 

To better understand how stock options work, let’s consider the example of a call option in Apple stock. Suppose we’re interested in the March 17 $160 call option, currently trading for $2.85.

 

This option will expire after the close on March 16 (Friday). Suppose the option is in-the-money at the close of trading. In that case, the buyer’s right to buy Apple at $160 per share will automatically be exercised.

 

The option’s strike price is $160, meaning the buyer has the right to purchase 100 shares of Apple stock at $160 per share until the expiration date.

 

It’s important to note that the option’s price is $2.85 per share. Still, since options are quoted in per-share terms, and each stock option represents 100 shares of the underlying stock, the total cost comes to $285.00. I know it’s confusing, but options are quoted this way to provide context. You can quickly look at an option price of $2.85 and think: “it’ll cost me $2.85 per share to participate in upside above the strike price of $160 until March 17. Is that a good deal?”

 

Putting it all together, the buyer of this stock option has the right to buy Apple stock at $160 per share at any time up until the expiration date of March 17.

 

What Are Index Options?

While similar to stock options in most respects, index options have some critical differences that traders should be aware of. To begin, let’s get clear on some basic definitions of what an index option is.

 

The buyer of an index option has the right, but not the obligation, to buy or sell a specific stock index at a predetermined price and date. In contrast to stock options, index options can only be exercised at the settlement date. In contrast, stock options can be exercised anytime up until settlement.

 

Let’s look at an example of an index option, just as we did with our Apple Stock Options example. Suppose we’re looking at call options on the S&P 500 index (ticker: $SPX). We find a call option for the March 17 expiration with a strike price of 4300 call option and a current price of $20.00 per contract.

 

In this case, if the option is in-the-money (meaning the S&P 500 index is trading above 4300) at the time of expiration, the option holder is paid the option’s cash value. For instance, if the S&P 500 is at 4350 at expiration, the option holder would have $5,000 credited to their trading account. This is because the option is $50 in-the-money (4350 – 4300 = 50), and each option contract is for 100 shares of the underlying asset (50 * 100 = 5,000).

 

So to summarize, this 4300 call option will settle for cash, the difference between the strike price of 4300 and the market price at settlement.

 

How Stock Options and Index Options Differ

Options settlement ensures that both the buyer and seller of an options contract fulfill their obligation. For example, settlement provides that the buyer of an Apple 160 call option receive their shares at the agreed-upon price of $160 per share. At the same time, the seller is obligated to provide said shares at that price.

 

But stock options and index options have slightly different settlement processes.
 

Index Options: Cash Settlement

Index options use a cash settlement process, where the two parties of the option contract don’t actually exchange the underlying asset at expiration. Instead, they settle up in cash. The cash value is determined through the difference between the strike price and the underlying asset’s market price at the time of settlement.

 

Suppose you own a call option on the S&P 500 index with a strike price of 4200 and the S&P 500 index is at 4300 at expiration. Instead of transferring shares as you would in a physical settlement, you’d simply receive the difference between the strike price and market price at expiration of $10,000.

 

Most traders prefer the cash settlement process, as it’s much simpler. No worries about being assigned, fussing with shares after settlement, etc. It’s clean–everything is transferred via cash.
 

Stock Options: Physical Settlement

Physical settlement involves exchanging the actual underlying asset between the buyer and seller of an option upon settlement of the contract. It’s called “physical” because it involves an actual transfer of shares instead of just settling up in cash, as index options do with cash settlement.

 

Let’s say you bought a put option on McDonald’s stock with a strike price of $260. When the option expires, McDonald’s stock is trading at $266 at expiration. In this case, the option is automatically exercised, and the seller of the option must sell you 100 shares of McDonald’s at $260 per share.

 

On the other hand, if you were the seller of that put option, and you sold that same put option, you’d be forced to sell the buyer of the option 100 shares of McDonald’s at $260. If you don’t have the shares to fulfill the assignment, your broker will buy them at the market price and use them to meet the assignment.

 

So if you’re selling “uncovered” options and don’t have the shares to fulfill an assignment, it’s generally best to close out the option before settlement.

 

Index Options Are More Tax-Efficient

On average, your tax liability for profitable index options will be lower than the equivalent stock options trade. This is because index options and stock options are taxed differently.

 

Stock option trades are taxed like ordinary stock trades. If the trade was open for less than a year, those profits would be taxed at the short-term capital gains rate, which is higher than the long-term capital gains rate.

 

But index options benefit from their designation as “1256” contracts, thanks to Section 1256 of the IRS Code. Regardless of the trade time frame, these contracts are taxed at a blended rate. Essentially, 60% of the profits are taxed at the long-term capital gains rate, and the other 40% are taxed at the short-term capital gains rate.

 

Index Options Require More Capital

Stock indexes tend to have higher prices than your average stock, which means index options, representing 100 shares of the underlying, can cost more. For instance, a 28-day at-the-money call option on the S&P 500 index could run you a whopping $8,600, as the index is currently sitting at 4,147.

 

On the other hand, consider the closest stock equivalent to the S&P 500 index, the SPDR S&P 500 ETF Trust, also known as SPY. The price of a call option at the same strike price would only cost you about $860 because SPY is one-tenth of the price of the S&P 500 index, currently at 413.98.

But there’s a huge caveat here. While it’s true that if you want to trade the most liquid and popular index options like $SPX, much more capital is required than your average stock trade, the CBOE recently gave undercapitalized traders more options.

 

The CBOE recently launched mini and nano options on the S&P 500 index, representing 1/10th and 1/100th of the size of an SPX option, respectively. For instance, an at-the-money call in mini SPX options would run you roughly $860, and the equivalent nano SPX option is approximately $86.

 

Keep in mind that these smaller contract sizes are very new and generally aren’t very liquid.
 

Stock Options Offer So Many Choices

According to FinViz, there are 5,343 optionable stocks listed on major US exchanges. Some stocks double or get chopped in half nearly every day in the stock market. There’s a wealth of opportunity for those willing to navigate smaller and less liquid markets.

 

On the other hand, there’s just a handful of stock indexes, along with the VIX, and they all pretty much move in tandem. Sometimes the major indices are quiet for long periods, and index options offer little in the way of opportunity.

 

For reference, here’s a list of the most popular and active index options:

List of Index Options

●     S&P 500 Index ($SPX)

●     Mini S&P 500 Index ($XSP)

●     Nano S&P 500 Index ($NANOS)

●     Nasdaq 100 Index ($NDX)

●     Russell 2000 Index ($RUT)

●     Dow Jones Industrial Average Index ($DJX)

●     S&P 500 Volatility Index ($VIX)

 

Bottom Line

Though similar to stock options in many ways, index options differ in a few key ways, such as settlement, expiration, and tax treatment.

 

Traders looking to maximize their profits in options trading shouldn’t limit themselves to the option market they started with. Stock, index, and futures options offer their own benefits and drawbacks.

Like this article? Visit our Options Education Center and Options Trading Blog for more.

Related articles

• Option Settlement: The Basics
• How Index Options Settlement Works
• Index Options Or ETF Options?
• Options Expiration: 6 Things To Know
• Early Exercise: Call Options 

But in this article, we’re going to show you why early assignment is a vastly overblown fear, why it’s not the end of the world, and what to do if it does occur.

 

What is Assignment in Options Trading?

Do you remember reading beginner options books or articles that said, “an option gives the buyer the right, but not the obligation, to buy/sell a stock at a specified price and date?” Well, it’s accurate, but only for the buy side of the contract.

 

The seller of an option is actually obligated to buy or sell should the buyer choose to exercise their contract. So when options, assignment is when you, the lucky seller of an options contract, get chosen to make good on your obligation to buy or sell the underlying asset.

 

Let’s say you sold a call option on a stock with a strike price of $50, which you held until expiration. At expiration, the stock trades at $55, meaning it’s automatically exercised by the buyer. In this case, you are forced to sell the buyer 100 shares at $50 per share.

 

So when selling options, assignment is when you, the lucky seller of an options contract, get chosen to make good on your obligation to buy or sell the underlying asset.

 

What is Early Assignment in Options Trading?

Early assignment is when the buyer of an options contract that you’re short decides to exercise the option before the expiration and begins the assignment process.

 

Many beginning traders count early assignments as one of their biggest trading fears. Many traders’ fear of early assignment stems from their lack of understanding of the process. Still, it’s typically not something to worry about, and we’ll show you why in this article. But first, let’s look at an example of how the process works.

 

For instance, say we collect $1 in premium to short a 30-day put option on XYZ with a strike price of $45 while the underlying is trading at $50. Fast forward, and it’s the morning of expiration day. Options will expire at the close of trading in a few hours. The underlying stock is hovering around $44.85. Our plan pretty much worked as planned until, for some reason, the holder of the option exercises the option. We’re confused and don’t know what’s going on.

 

It works exactly the same way as ordinary options settlement. You fulfill your end of the bargain. As the seller of a put option, you sold the right to sell XYZ at $45. The option buyer exercised that right and sold his shares to you at $45 per share.

 

And now, let’s break down what happened in this transaction:

• You collected $1 in premium when opening the contract
   
• The buyer of the option exercises his right to sell at $45 per share.
   
• You’re now long 100 shares of XYZ that you paid $45 for, and you sell them at the market price of $44.80 per share, realizing a $0.20 per share loss.
   
• Your profit on the transaction is $0.80 because you pocketed $1 from the initial sale of the option but lost $0.20 from selling the 100 shares from assignment at a loss.

 

Why Early Assignment is Nothing to Fear

Many beginning traders count early assignments as one of their biggest trading fears; on some level, it makes sense. As the seller of an option, you’re accepting the burden of a legitimate obligation to your counterparty in exchange for a premium. You’re giving up control, and the early assignment shoe can, on paper, drop at any time.

 

Exercising Options Early Burns Money

People rarely exercise options early because it simply doesn’t make financial sense. By exercising an option, you’re only capturing the option’s intrinsic value and entirely forfeiting the extrinsic value to the option seller. There’s seldom a reason to do this.

 

Let’s put ourselves in the buyer’s shoes. For instance, we pay $5 for a 30-day call with a strike price of $100 while the underlying is trading at $102. The call has $2 in intrinsic value, meaning our call is in-the-money by $2, which would be our profit if the option expired today.

 

The other $3 of the option price is extrinsic value. This is the value of time, volatility, and convexity. By exercising early, the buyer of an option is burning that $3 of extrinsic value just to lock in the $2 profit.

 

A much better alternative would be to sell the option and go and buy 100 shares of the stock in the open market.

 

Viewed in this light, an option seller can’t be blamed for looking at early assignment as a good thing, as they get to lock in their premium as profit.

 

Your Risk Doesn’t Change

One of the biggest worries about early assignment is that being assigned will somehow open the trader up to additional risk. For instance, if you’re assigned on a short call position, you’ll end up holding a short position in the underlying stock.

 

However, let me prove that the maximum risk in your positions stays the same due to early assignment.

 

How Early Assignment Doesn’t Change Your Position’s Maximum Risk

Perhaps you collect $2.00 in premium for shorting an ABC $50/$55 bear call spread. In other words, we’re short the $50 call for a credit of $2.50 and long the $55 call, paying a debit of $0.50.

 

Before considering early assignment, let’s determine our maximum risk on this call spread. The maximum risk for a bear call spread is the difference between the strike minus the net credit you receive. In this case, the difference between the strikes is $5, and we collect a net credit of $2, making our maximum risk on the position $3 or $300.

 

You wake up one morning with the underlying trading at $58 to find that the counterparty of your short $50 call has exercised its option, giving them the right to buy the underlying stock at $50 per share.

 

You’d end up short due to being forced to sell the buyer shares at $50. So you’re short 100 shares of ABC with a cost basis of $50 per share. On that position, your P&L is -$800, the P&L on a $55 long call is +$250, on account of you paying $0.50, and the call being $3.00 in-the-money. And finally, because the option holder exercised early, you get to keep the entire credit you collected to sell the $50 call, so you’ve collected +$250.

 

So your P&L is $300. You’ve reached your max loss. Let’s get extreme here. Suppose the price of the underlying runs to $100. Here are the P&Ls for each leg of the trade:

• Short stock: -$5,000
   
• Long call: +$4,450
   
• Net credit received from exercised short option: +$250
   
• 5,000 – (4,450 + 250) = $300

 

While dealing with early assignments might be a hassle, it doesn’t open a trader up to additional risk they didn’t sign up for.

 

Margin Calls Usually Aren’t The End of the World

Getting a margin call due to early assignment isn’t the end of the world. Believe it or not, stock brokerages have been around for a long time. They have seen early assignments many times before, and they have protocols for it.

 

Think about it intuitively, your broker allowed you to open the short option position knowing that the capital in your account could not cover an early assignment. Still, they let you make the trade anyways.

 

So what happens when you get an early assignment that you can’t cover? Your broker issues you a margin call. Once you’re in violation of their margin rules, they pretty much have carte blanche to handle the situation as they wish, including liquidating the assigned stock position at their will.

 

However, most brokers will give you some time to react to the situation and either decide to deposit more capital, liquidate the position on your own, or exercise offsetting options to fulfill the margin call in the case of an option spread.

 

Even though a margin call isn’t fun, remember that the overall risk of your position doesn’t change due to an early assignment, and it’s typically not a momentous event to deal with. You probably just have to liquidate the trade.

When Early Assignment Might Occur?

 

Dividend Capture

One of the few times it might make sense for a trader to exercise an option early is when he’s holding a call that is deep in-the-money, and there’s an upcoming ex-dividend date.

 

Because deep ITM calls have very little extrinsic value (because their deltas are so high), any negligible extrinsic value is often outweighed by the value of an upcoming dividend payment, so it makes sense to exercise and collect the dividend.

 

Deep In-The-Money Options Near Expiration

While it’s important to emphasize that the risk of early assignment is very low in most cases, the likelihood does rise when you’re dealing with options with very little extrinsic value, like deep-in-the-money options. Although, even in those cases, the probabilities are pretty low.

 

However, an options trader that is trading to exploit market anomalies like the volatility risk premium, in which implied volatility tends to be overpriced, shouldn’t even be trading deep-in-the-money options anyhow. Profitable option sellers tend to sell options with very little intrinsic value and tons of extrinsic value.

 

Bottom Line

Don’t let the fear of early assignment discourage you from selling options. Far worse things when shorting options! While it’s true that early assignment can occur, it’s typically not a big deal.

Related articles

• Can Options Assignment Cause Margin Call?
• Assignment Risks To Avoid
• The Right To Exercise An Option?
• Options Expiration: 6 Things To Know
• Early Exercise: Call Options
• Expiration Surprises To Avoid
• Assignment And Exercise: The Mental Block
• Should You Close Short Options On Expiration Friday?
• Fear Of Options Assignment
• Day Before Expiration Trading
• Accurate Expiration Counting

 

After all, at their core, options are just contractual agreements between a buyer and seller to potentially do a transaction on a specific date. And the process that ensures that the transaction, or lack thereof, goes smoothly is called options settlement.

 

What is Option Settlement?

Options settlement is a fulfillment of the contractual conditions in an options contract. In other words, settlement ensures that the two parties to an options contract get what is owed to them.

 

But there are different types of options contracts. Luckily for us, in the listed options market, there are only two types of options: American-style and European-style. European options are cash settled, while American options settle physically.

 

This article will focus on the cash settlement process and how it works.

 

Cash Settlement in a Nutshell

A call option is the right to buy an asset at a specified price and date. This is a straightforward concept in theory, but in practice, complications arise.

 

For instance, there are options listed on the S&P 500 Volatility Index (VIX), but the VIX isn’t actually a tradable security. It’s simply a mathematically derived formula that other securities derive value from. You can’t go and buy a share of VIX.

 

So how does a call option on such an index work?

 

That’s where cash settlement and European options come in. Basically, cash-settled options don’t require the transfer of the underlying asset (which would be impossible in this case), and instead involve the direct transfer of cash between the two parties of the option contract.

 

For instance, let’s say we own a call option on the VIX index with a strike price of $19, and at expiration, the VIX index is at $22.50, making the intrinsic value of our call option $3.50 at expiration. So the seller transfers $3.50 to us at expiration, and no transference of VIX is required.

 

And this entire cash settlement process is handled by the Options Clearing Corporation (OCC), a clearinghouse, and both parties to the trade have their accounts debited or credited the correct amount.

 

Why Cash Settlement Is Better Than Physical Settlement

Cash settlement dramatically simplifies things for options traders. With the simple automatic cash transfer between parties settling things, traders can hold cash-settled options into expiration without issue.

 

On the other hand, Physically settled options can create all types of problems for traders. One of the biggest annoyances with physically settled options

 

For one, getting assigned early and being forced to buy or sell 100 shares of stock they had no interest in owning or having a short position in. And for this reason, traders of physically settled options always have to make sure they close their positions before expiration. Otherwise, they might end up owning shares of stock they don’t want.

 

Options Style: American vs. European Options

Remember, two distinct styles of options trade on listed markets: European and American.

 

And distinguishing between them is simple. If you’re trading an option on a stock or ETF, that is an American option.

 

Other types of options, like those listed on an index (like in our VIX example) or futures options, are primarily European options, with a few exceptions.

 

Regarding practical differences, there are really only two differences to note between American and European options: when they can be exercised and how they settle.

 

American Options	European Options
Can be exercised at any time prior to expiration	Can only be exercised at expiration
Physical settlement; actual transfer of underlying asset.	Cash settlement; intrinsic value is transferred in cash to the holder at expiration.

 

Examples of Cash Settled Options

Now let’s take a look at the different types of assets that have European or American-style listed options listed:

 

American Options	European Options
US stocks and ETFs (like AAPL and SPY)	Cash indexes (like VIX or SPX)
	Most futures, with some key exceptions. Always check contract specifications on the exchange website.

 

A Common Misconception: European Options Do Trade on Exchanges

Many popular articles about the differences between American and European options report that European options tend to trade over-the-counter (OTC), while American-style options trade on exchanges. This is inaccurate.

 

For instance, S&P 500 Cash Index (SPX) options, which are options on the untradable cash index of the S&P 500, trade on the CBOE. Another example is most E-mini S&P 500 futures (/ES) options, which are also European-style and trade on the CME.

 

Bottom Line

To wrap things up, only European options are cash-settled. Cash settlement involves simply transferring the intrinsic value in cash at expiration. Examples of European options are those traded on indexes like the SPX or VIX, as well as most futures options. In contrast, all US stock options, like AAPL, MSFT, or SPY, are American-style and settle via physical delivery of shares.

Related articles

• Option Settlement: The Basics
• How Index Options Settlement Works
• Can Options Assignment Cause Margin Call?
• Assignment Risks To Avoid
• The Right To Exercise An Option?
• Options Expiration: 6 Things To Know
• Early Exercise: Call Options
• Expiration Surprises To Avoid
• Assignment And Exercise: The Mental Block
• Fear Of Options Assignment
• Expiration Short Strategies

 

Looking at a common situation, suppose that you have written a covered call. You owned 300 shares of YFS (Your Favorite Stock Inc.), watched it rally, and finally decided that it’s time to sell the shares because you believe they are fully priced at $41 per share.

 

Instead of selling the shares outright, you decided to milk this trade for additional profits and wrote three YFS March 40 Calls, collecting a premium of $2.50. If the stock is above $40 when expiration arrives, you will sell the shares at $40. Adding the option premium, your net is $42.50 instead of $41. Sure, there’s some downside risk prior to expiration, but you decide to accept that risk.

 

All goes well, the stock rallies further and when it’s trading at $44, you are surprised to be assigned an exercise notice because it’s one week before expiration. There was no reason for the option owner to exercise and the stock did not go ex-dividend. Nevertheless, you sold your stock, earned your profit and even collected the cash one week early. This is all good.

 

In most cases that’s the end of the story. However, on this occasion you learn the importance of not exercising an option earlier than necessary. On Monday and Tuesday of expiration week, overseas markets tumbled and the U.S. market followed suit. On top of that, YFS issues some minor news that, under ordinary market conditions, would have been shrugged off.  However, with the nervous market and a substantial two-day decline, YFS fell out of bed. When the market opened Wednesday morning, it was trading south of $37 per share.

 

If you had not been assigned early, you would own stock and have no chance to sell at $40. So give a big “thank you” to the person who made the terrible decision to exercise.

 

Think of it this way — it’s exactly the same as if the person who exercised your calls said to you:

 

“Here is a FREE put option. I’m taking your stock now and in its place you now own three March 40 YFS put options. If the stock trades below $40 next week, you will have the right to sell those shares at $40. In reality you already sold the shares, but because most stockholders were not assigned an exercise notice, I’ve given you a special gift: three put options. I did this because I am certain these puts are worthless, but they are yours with my compliments.”

 

Of course, the exerciser does not truly think that way or else he/she would have never exercised early. This time you were saved from taking a loss. If YFS dips low enough that you want to repurchase the shares, you are in position to do so. If you still owned the original shares, you would not have the ready cash to make that choice.

 

Being assigned on a call option is the same as being handed a free put. Being assigned early on a put option is equivalent to being handed a free call. These “imaginary, free” options have the same strike and expiration date as the real options on which you were assigned.

 

Don’t be unhappy when assigned. It can be a rare gift.

Like this article? Visit our Options Education Center and Options Trading Blog for more.

 

Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.

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• Everything You Need To Know About Options Assignment Risk
• Can Options Assignment Cause Margin Call?
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• The Right To Exercise An Option?
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• Early Exercise: Call Options
• Expiration Surprises To Avoid
• Assignment And Exercise: The Mental Block
• Should You Close Short Options On Expiration Friday?
• Fear Of Options Assignment

 

Managing portfolio volatility is a critical aspect of investing, and there are many strategies available to accomplish this goal. The covered call strategy is one of the most popular strategies for managing portfolio volatility. In this blog, we will discuss how to use the finest covered call strategy to manage portfolio volatility.

 

What is a Covered Call?

A covered call is an options trading strategy that involves owning a stock and selling call options on that stock. By doing so, the investor receives a premium (i.e., payment) for selling the option, which provides some downside protection in case the stock price falls. At the same time, the investor limits their upside potential, as they have agreed to sell the stock at a specific price (the “strike price”) if the stock price rises above that level.

 

What is a Covered Call in the Stock Market?

A covered call is an options strategy that involves selling call options on a stock that you already own. A call option gives the buyer the right, but not the obligation, to purchase the underlying stock at a specific price (known as the strike price) on or before a particular date (known as the expiration date). When you sell a call option, you receive a premium from the buyer, which you get to keep regardless of whether the option is exercised or not.

 

The key to a covered call strategy is that you already own the underlying stock. If the option is exercised, you sell your stock at the strike price and keep the premium you received from selling the option. If the option is not exercised, you keep the stock and the premium, and you can sell another call option in the future if you choose.

 

How does the Covered Call Strategy work?

The covered call strategy involves three main steps: 

• Buy Stock: The investor purchases shares of a stock they want to hold in their portfolio.
   
• Sell Call Option: The investor sells a call option on that stock. The call option represents the right (but not the obligation) for another investor to purchase the stock at a specific price (the strike price) within a particular timeframe (the expiration date).
   
• Manage the Option: As the option seller, the investor can choose to either let the option expire worthless (if the stock price remains below the strike price) or buy back the option (if the stock price rises above the strike price). In either case, the investor keeps the premium received for selling the option.

 

By following these steps, the investor can reduce the volatility of their portfolio by collecting premium income from the options while maintaining some upside potential from the stock they own.

 

A Covered Call Strategy Benefits from What Environment?

The covered call option strategy benefits from a market environment where the stock price is stable or slightly bullish. In this environment, you can sell call options at a strike price that is slightly above the current stock price, which means that the option is less likely to be exercised, and you get to keep the premium. If the stock price does rise above the strike price, you still profit from the sale of the stock and the premium.

 

Advantages of Covered Call Strategy

The covered call strategy offers several advantages for managing portfolio volatility:

 

• Downside Protection: By selling a call option, the investor receives a premium that provides some protection against potential losses in the stock. If the stock price falls, the option premium can offset some of the losses.
   
• Income Generation: The premium received for selling the call option provides additional income to the investor, which can help enhance the overall returns of their portfolio.
   
• Limited Risk: The investor’s risk is limited to the stock price minus the premium received for selling the call option. This can provide a level of comfort for investors who are hesitant to take on too much risk.
   
• Flexibility: The investor can choose to sell options with different strike prices and expiration dates, allowing them to tailor the strategy to their risk tolerance and investment goals.

 

Living off Covered Calls

One of the main benefits of using a covered call strategy is that it can provide investors with a consistent income stream. Investors can generate additional income from their holdings by selling call options on stocks they already own. By selling call options, you receive premium income, which can be used to supplement your income or reinvest back into your portfolio. This can be particularly useful for investors who are dreaming of living off covered calls and their investments in retirement.

 

Call Markets

A call market is a market where trading occurs at specific times of the day rather than continuously throughout the day. In a call market, investors submit orders to buy or sell securities at a particular price, and these orders are executed at a predetermined time. Covered call alerts can be particularly useful in call markets, as they can help investors identify potential trading opportunities when the market is open.

 

When stocks rise or fall in a call market, it can lead to the opportunity to sell covered calls for higher premiums. In a volatile market, premiums can increase, which means that you can earn a higher income from selling call options. However, it is important to be careful when selling covered calls in a volatile market, as it may increase the risk of having the stock called away.

 

What is a Covered Call Alert?

Before diving into the details of covered calls, it is important to understand what a covered call alert is. A covered call alert is a notification system that alerts investors when a particular stock meets certain criteria for a covered call trade. These alerts are typically generated by software programs that use algorithms to identify stocks that meet specific criteria.

 

A covered call alert is a tool that can help you identify potential covered call opportunities. The alert system monitors your portfolio and provides alerts when a stock meets specific criteria, such as having high implied volatility or an upcoming earnings announcement.

 

Best ETFs for Covered Calls

If you are looking to implement a covered call strategy in your portfolio, there are several exchange-traded funds (ETFs) that can help. These ETFs typically invest in stocks and sell call options to generate income. Some of the best ETFs for covered calls include the Invesco S&P 500 BuyWrite ETF (PBP) and the Global X NASDAQ 100 Covered Call ETF (QYLD). These ETFs offer investors exposure to a broad range of stocks while also providing the potential for additional income through the sale of call options.

 

Conclusion

The covered call strategy can be an effective way to manage portfolio volatility by reducing downside risk and generating additional income. However, like any investment strategy, it’s important to understand the risks and potential rewards before implementing the system in your own portfolio. Consult with a financial advisor or do thorough research to ensure that the plan is appropriate for your individual circumstances and investment goals.

 

In conclusion, a covered call strategy can be an effective way to manage portfolio volatility while generating income. By selling call options on stocks you already own, you can reduce risk and potentially earn revenue. It is important to remember that covered call strategies involve risk and may not be suitable for all investors, so be sure to consult with a financial advisor before implementing this strategy in your portfolio. 

 

AUTHOR BIO:

Adrian Collins works as an Outreach Manager at OptionDash. He is passionate about spreading knowledge on stock and options trading for budding investors. OptionDash ensures to offer the best Covered Call and Cash Secured Put Screener on the internet.