Now that you have a basic understanding of calls and puts, we’ll need to spend some time adding market terminology to your foundation. The financial markets are filled with colorful terminology and half the battle for new option investors is interpreting the jargon. It’s like learning a new language. However, if you understand the terminology, you’ll find that options aren’t so difficult. Because of this, we’re going to spend some time going through the various terms you need to understand as you continue to explore the world of options.
The Long and Short of It
The previous course stated that the buyers and sellers are on opposite sides of the transaction. Loosely speaking, that is true. However, to truly understand the roles of the buyers and sellers, we need to introduce the terms “long” and “short,” which are two of the most common terms you will hear in the financial markets.
If you buy any financial asset, you are “long” the position. For example, if you buy 100 shares of IBM then you are long 100 shares of IBM. The term “long” just means you paid money for it and you own it. Likewise, if you buy a call option, you are “long” the call option.
Investors with long positions are bullish on its price; that is, they believe the price will rise. (The term bullish is derived from the way a bull attacks. It lowers its horns and then raises them high. So if you think prices are moving from low to high you are bullish.)
The Short Position
You would certainly think that if “long” means you bought the asset then “short” must mean that you sold it but that’s not quite right. We can demonstrate why with a simple example. If you are long 100 shares of IBM and you then sell 100 shares you are not short shares of IBM – even though you sold 100 shares. That’s because you first purchased them so after the sale you have no shares.
However, let’s say you bought 100 shares of IBM and then, by accident, entered an order online to sell 150 shares of IBM. The computer will execute the order since it has no way of knowing how many shares you actually own (maybe you have shares in a safe deposit box or with another broker). But if you really only owned 100 shares then you would be “short” 50 shares of IBM once the order has executed.
In other words, you sold 50 shares you don’t own and now must buy 50 shares to return them to the broker. And that’s exactly what it means to be short shares of stock. It means you sold shares you do not own. However, when traders short shares in the financial market, it’s not done by mistake – it is done intentionally. How can you intentionally sell shares you don’t own? You must borrow them.
Traders use short sales as a way to profit from falling stock prices. Traders with short positions are bearish on their price. (The term bearish is named after the way a bear attacks with its claws. It raises them high and swings down low. If you think prices are moving from high to low, you are bearish.)
Let’s take a look at a quick example of a short sale. Assume IBM is trading for $100 and you think its price is going to fall. If you are correct, you could profit from this outlook by entering an order to “short” or “sell short” shares of IBM. Let’s assume you decide to short 100 shares. Your broker will find 100 shares from another client and let you borrow these shares. Although this sounds like a lengthy, complicated transaction, it takes only seconds to execute.
While this may sound like a secretive, unethical thing to do, it is perfectly legal and done all the time. In fact, similar actions are done by many types of financial institutions and not just brokers. For example, assume you borrow $10,000 from a bank. The banker finds this cash from an account holder at the bank and loans you the funds. That account holder never knows the money is missing. If he checks his account at any time, he will see the $10,000 cash in the account even though it is technically not there. If he ever wishes to withdraw that money before your loan is repaid, the banker must find $10,000 from yet another account holder to return to the original lender. The entire process is seamless to the account holders and goes on each and every day at a bank.
In a similar way, if you wish to short 100 shares of IBM, your broker finds 100 shares from another account holder. If that account holder ever wishes to sell his shares, the broker must find the 100 shares from yet another account holder and return them to the original lender. How can your broker do this without your consent? He actually does have your consent. It’s all part of the contract when you sign a margin agreement account form, which is required for you to short shares of stock.
So if you wish to short shares of stock, your broker must find shares for you to borrow. Once the shares are located, you can then sell them in the open market as if you owned them. Assume you sell the 100 shares for $100. Once the order is executed, you will have $10,000 cash sitting in your account (sold 100 shares at $100 per share) and your account shows that you are short 100 shares of IBM; that is, you sold shares that you do not own.
If you look at your positions in the account, you will see IBM -100 shares. The minus sign means you owe 100 shares back to the broker in order to get the balance to zero, which is also called “flat” in the brokerage business.
Let’s assume that the price of IBM later drops by $5 to $95 and you decide to buy back the shares. You would enter an order to buy 100 shares and spend $9,500 of the $10,000 cash you initially received from selling shares. Once you buy the 100 shares, your obligation to return the IBM shares is then satisfied and you are left with an extra $500 in your account. In other words, the short sale allowed you to profit from a falling stock price.
This profit can also be found by multiplying the number of short shares by the drop in price, or 100 shares * $5 fall in price = $500 profit. If you have shorted 500 shares, you would have ended up with 500 shares * $5 = $2,500 profit.
Of course, if the price of IBM had risen at the time you purchased them back, then you’d be left with a loss since you must spend more than you received to return the shares.
Short selling works because you are obligated to return a fixed number of shares and not a fixed dollar amount. In our example, you shorted 100 shares with a value of $10,000. Your obligation is to return 100 shares of IBM and not $10,000 worth of IBM. If you can purchase the shares for less money than you received, you will make a profit.
Short sellers profit in the same way as stock buyers by entering the same transactions, just in the opposite order. For instance, when you buy stocks, you want to buy low and sell high. When you short stocks, you want to sell high and buy low. The order of the transactions does not affect your profitability as long as the purchase price is less than the selling price.
This is not meant to be a course in shorting stocks. Instead, we introduced it so you have a solid understanding of what the term “short” really means when applied to the stock market. Shorting means you receive cash from selling an asset you don’t own and then incur some type of obligation. If you short shares of stock, you have the obligation to buy back the shares at a future date. (To learn more about short selling, click here.)
Shorting an option has the same meaning. If you short an option, you have sold something you don’t own. All you’ve done is accepted cash in exchange for incurring some type of obligation, which of course depends on whether you sold a call or put. As a refresher from the previous course, if you short a call, you have the obligation to sell shares of stock. If you short a put, you have the obligation to buy shares of stock.
As with a short stock sale, the cash from selling the option is credited to your account immediately and is yours to keep regardless of what happens to the option. The cash is cleared and immediately available for you to use as you wish. That is your compensation for accepting an obligation.
It is the short option sellers who accept an obligation. In the previous course, we said that it is the “sellers” who accept some type of obligation but now that you understand the terms long and short, we can refine that definition. Just because you sold an option does not mean you are short the option. Just as with shares of stock, if you purchased the option first then sold it, you are not short the option. It’s only when you enter into the agreement by first selling the option.
It is the long positions that have rights while the short positions have obligations. This arrangement is required to make the options market work. Both the buyer and seller cannot have rights. Both cannot buy nor can they both sell. One side has the right to buy (or the right to sell) while the opposite side has the obligation to complete the transaction.
This connections between the long and short positions is often a source of confusion for new option traders. They often hear that options traders have rights and wonder how the market can work if everybody has a right to buy or sell. The answer is that it is only the long positions that have rights. The short positions have obligations.
If you choose to use your coupon and buy one pizza, the store owner must deliver. You have the right; he has the obligation. As stated previously, this is not a perfect analogy since no money changes hands between the buyer and seller of pizza coupons. However, we’re just making sure you understand the role of the long and short positions.
If you buy an auto insurance policy you are “long” the policy and have the right to “put” your car back to the insurance company. The insurance company is “short” the policy; they receive money in exchange for the potential obligation of having to buy your car from you (or pay some other claim). Whether you make a claim or not, the insurance company keeps your premium just as you will when selling options. That’s their compensation for accepting the risk.
The Options Clearing Corporation (OCC)
We’ve stated that the long option position is the one who makes the decision whether the contract will get used or not. If he decides to use the option, the short position must oblige. How can you be sure the short position will follow through with their obligations if you decide to use your call or put option?
The answer is that there is a clearing firm called the Options Clearing Corporation, or OCC. The OCC is a highly capitalized and regulated agency that acts as a middleman to all transactions. When you buy an option, you are really buying it from the OCC. And when you sell an option, you are really selling it to the OCC. The OCC acts as the buyer to every seller and the seller to every buyer. It is the OCC that guarantees the performance of all contracts.
By “performance” we obviously do not mean profits but rather that if you decide to use your option, you are assured the transaction will go through. In fact, ever since the inception of the options market and the OCC in 1973, not a single case of failure to perform or partial performance has ever occurred. If you’d like to read more about the OCC, you can find its website at www.OptionsClearing.com.
Closing Transactions (The Great Escape)
We just found out that you can get into an option contract by either buying or selling a call or put. But once you’re in the contract, is there a way to get out of it at a later time? The answer is yes. All you have to do is enter a closing transaction (also called a reversing trade). In other words, you can always end any contract by entering the reverse set of transactions that got you into it in the first place.
If you are long a contract, you can get out of it by selling the same contract. And probably more important, if you are short an option contract, you can always “escape” your obligations by simply buying the same contract back.
This is exactly the same idea of how you escape from your obligations if you are short shares of stock. If you are short 100 shares of IBM, you can end all obligations and risks by purchasing 100 shares of IBM. The long and short positions cancel each other out and you’re left with a resulting profit or loss.
In the same way, just because you can put an end to your obligations doesn’t mean that you can avoid any losses that may have accrued. The price you pay to get out of a short option contract may be higher and, in some cases, much higher than the price you originally received from selling it. But the point is that you can always get out of a short option contract by simply buying it back.
There are many types of option contracts and each is designed to give traders the right to buy or sell many different types of assets. For this course, the asset will always be shares of stock, which are called equity options or stock options. But you can buy and sell options covering other assets such as ETFs (Exchange Traded Funds), foreign currencies, and futures contracts. Whatever the asset you’re controlling may be it is called the underlying asset. In the pizza coupon example, we would say the underlying asset is a pizza. So for this course, the underlying asset will always be shares of stock unless otherwise stated.
The price of an option is tied to or derived by the underlying stock. Because of this, options are one of many types of derivative instruments. A derivative instrument is one whose value is derived by the value of another asset.
Recall that the pizza coupon limited us to how many pizzas we can purchase; we cannot purchase all we want. In addition, the coupon is not good for any brand of pizza but only the one advertised on the coupon.
Call and put options work in similar ways. As mentioned earlier, the underlying asset for a call or put option is generally 100 shares of stock. There are exceptions to this rule such as with certain stock splits and mergers. But when options are first listed, they always control 100 shares of the underlying stock.
We would say the “contract size” for equity options is 100 shares. Of course, if the number of shares is changed due to a stock split then the contract size will change as well. The contract size just tells us how many shares of stock the option controls.
The “brand” of shares we can buy is determined by the call or put option. For example, if you own a Microsoft call option, you have the right to buy 100 shares of Microsoft. In this case, Microsoft would be the underlying stock.
Strike Price (Exercise Price)
In our example, the pizza coupon states a specific purchase price of $10. No matter how high of a price the store may be charging, you are locked in to the price of $10. If this were an option, we'd call this “lock in” price the strike price, which is really a slang term that comes from the fact that you and another trader have “struck” a deal at that price.
Another name for the strike price is the exercise price. The reason for this is that if you choose to use your option, you must submit exercise instructions to your broker, which is usually handled with a simple phone call or online request. With a pizza coupon, you just “hand in” the coupon but in the world of options you must “exercise” the option through your broker. (As a reminder, you are not required to exercise your option; you can just sell it instead. But if you decide to use it, you must submit exercise instructions.)
One of the key characteristics for pizza coupons and call options is that they have an expiration date. You can use your coupon at any time up to and including the expiration date.
Although pizza coupons can be set to expire whenever the store owner wishes, options are standardized contracts and have set expiration dates. For practical purposes, equity options expire on the third Friday of the expiration month.
Technically, equity options expire on Saturday following the third Friday of the expiration month but that is really for clearing purposes. That extra day (Saturday) gives the OCC time to match buyers and sellers while the contract is still legally “alive.” If the contract truly expired on Friday, the OCC could not allow exercises and assignments to take place on the weekend.
The important point to understand is that the last day to close your position (enter a reversing trade) or exercise your option is the third Friday of the expiration month. After that, it's no longer valid. It’s important to remember that options can be bought, sold, or exercised at any time but the third Friday is your last day to do so.(If Friday is a holiday, the last trading day will be the preceding Thursday.)
So just because you may read that options expire on Saturday, don’t think you can get up Saturday morning and call your broker with exercise instructions – it’s too late. Is it possible to get an extension? Although a pizza storeowner may allow you to turn in an expired coupon, there’s no such thing with the options market. The second that option expires, it’s gone for good.
There are some index options, such as options covering the S&P 500 Index that expire on the third Thursday of the expiration month. But as we said before, this course only covers equity options so whenever we talk about the expiration date, we will always be referring to the third Friday of the expiration month unless otherwise stated.
Also, because of the numerous contracts that must be accounted for, most brokerage firms enforce cutoff times after which you cannot submit exercise instructions. These deadlines may be well before the market closes. If you ever wish to exercise an option, check with your broker prior to expiration to be sure you know the cutoff time and proper procedures for submitting exercise instructions.
Physical versus Cash Delivery
If you exercise an equity option, you will either buy or sell the actual (physical) shares of the underlying stock. This is called physical delivery or physical settlement.
On the other hand, most index options, such as SPX (S&P 500), are cash settled rather than physical delivery. In other words, if you exercise an index option, you receive the cash value of the option rather than taking actual delivery of all the stocks in that index. Just understand that not all options settle in physical delivery.
American vs. European Styles
As you now know, if you wish to physically trade shares of stock, you must exercise your option. While we just learned that equity options can be exercised at any time prior to expiration, there are some styles of options that cannot. As you continue to learn about options, you will certainly encounter the different styles of options so we want to give them a brief mention here.
There are two styles of options: American and European. The style of option has nothing to do with its origin as implied by the names “American” and “European.” Instead, the style simply tells us when the option may be exercised. American style options can be exercised at any time through the third Friday of the expiration month. European style options, on the other hand, can only be exercised on the third Friday of the expiration month.
When it comes to equity options (options on stock), you do not get to select which style you want. All equity options are American style and can be exercised at any time.
Most index options, on the other hand, are European style. Index options work the same as equity options with one significant difference; they are usually settled in cash rather than the actual shares of stock in the index. If you own an index option such as the S&P 500 (SPX), you can only exercise at expiration.
There are a few indices that offer both styles such as the S&P 100 (OEX) which is American style while the XEO (letters reversed) is the European counterpart. Therefore, if you own an OEX index option, you can exercise it at any time. If you own an XEO option, you are still participating in the price changes of the OEX index but can only exercise at expiration.
This course is written from the perspective of equity options. We only introduce the terms American and European so you will know what they mean if you hear them later while continuing to learn about options. The bottom line is that all equity options are American style, which means the long position can exercise them at any time during the life of the option.
Exercise versus Assign
We said earlier that it is the long positions that get to decide whether or not to exercise their options. What do short positions get to decide? Nothing. Remember, short positions have no rights.
Short positions receive cash in exchange for accepting an obligation. If you are short an option, you should get a notification from your broker stating that you have just purchased or sold shares of stock due to an option you sold. If you are required to buy or sell shares of stock due to a short option, it is called an assignment.
If you get assigned on an option, many brokers will call the next business day to inform you of the assignment. He may say something like, “I’m calling to inform you that you’ve been assigned on your short call options and have sold 100 shares for the strike price of $50” or “You have been assigned on your short puts and just purchased 100 shares of stock for the $40 strike price.” If your brokerage firm doesn’t have a policy to call, they should at least notify you by email or other electronic means.
The words exercise and assign should technically only be associated with long and short positions respectively. When you start trading options though, you will hear people (including brokers) say things like “you got exercised” on an option even though it is technically incorrect. Long positions exercise. Short positions get assigned.
In practice, it doesn’t really matter if an incorrect phrase is used such as “you got exercised” rather than “you got assigned” as long as you understand the message. However, if the term “exercise” or “assigned” is used, you do need to understand the difference. Most books and literature on options carefully choose between the words “exercise” and “assign” so it’s important that you understand what they mean.
Let’s run through some examples to be sure you understand. If you are long a call option, you have the right to exercise it and buy shares of stock. You will send cash in the amount of the strike price (exercise price) and receive shares of stock.
If you are long a put option, you have the right to exercise it and sell shares. You will deliver shares and receive the strike price. If you are short the put option, you could get assigned and be required to buy shares. You will buy shares and deliver cash in the amount of the strike price. The long put owner would say, “I exercised my put” while the put seller (short put) would say “I got assigned.” Again, the following diagram may help you to understand the process.If you are short the call, you might get assigned and be required to sell the shares. You will receive cash in the amount of the strike price and deliver shares of stock. The long call owner would say, “I exercised my call” while the call seller (short call) would say “I got assigned.” The following diagram may help you to visualize the relationships:
If you are long a put option, you have the right to exercise it and sell shares. You will deliver shares and receive the strike price. If you are short the put option, you could get assigned and be required to buy shares. You will buy shares and deliver cash in the amount of the strike price. The long put owner would say, “I exercised my put” while the put seller (short put) would say “I got assigned.” Again, the following diagram may help you to understand the process.
All option assignments are done on a random basis through the OCC (Options Clearing Corporation). If you exercise an option, you have no idea who the person is on the short side that will be assigned. Nobody knows. It is strictly the person who ends up with the random assignment from the OCC. However, you can be assured that the transaction will go through; that is one of the functions of the Options Clearing Corporation.
If you have a short option position in your account and you close it by entering a reversing trade, you can be assured that you will not get assigned. All assignments are done after the market closes.
It is important to understand that once you submit exercise instructions to your broker and the shares and cash have exchanged hands it is an irrevocable transaction. Make sure you are confident in your decision before submitting instructions.
Calls and puts are the building blocks for every option strategy you will ever encounter. This is why we have spent so much time discussing the rights and obligations that they convey. As you advance with your option studies, you’ll find that most of the advanced strategies can be quickly figured out just by understanding who has the right and who has the obligation.
There’s still more terminology to discuss. However, before we do, it is necessary to introduce you to the mechanics of real call and put options which are the topic of our next course.