Series 7

AAA

Derivatives - Option Positions

There is one more way for options to be classified:

Whether a contract is covered or uncovered has a great deal to do with the margin, or credit, required of the parties involved.

  • Covered Call
    A call writer may be required to deliver the stock if the buyer exercises his option. If she has the shares on deposit with her broker, then she has written a covered call. There is no margin requirement for a covered call; that is, because the underlying securities are sitting right there, there is no question of creditworthiness

  • Uncovered Call
    If the call writer does not have the underlying shares on deposit, she has written an uncovered call, which is much riskier for the writer than a covered call.
    • If the buyer of a call exercises the option to call, the writer will be forced to buy the asset at the spot price and, since there is no limit to how high a share price can go, that spot price can theoretically go up to an infinite amount of dollars.

    • Remember the first example in this section on derivatives, in which the writer had to sell a big block of $38 stock for $25?

    • That is a $13 loss incurred 50,000 times, meaning the writer would have been out $650,000 if he had sold an uncovered call.

    • If he had sold a covered call and he had bought the stock at the $20 spot price at the time of the opening transaction, then he would be out $5 50,000 times, or $250,000.

    • That is still a bad outcome, but far less difficult to explain to a supervisor than $650,000 - and that $650,000 is not even that bad when you consider that there is really no limit to how much one can lose on an uncovered call.

  • Covered puts are options positions where the writer has cash on deposit equal to the cost to purchase the shares from the holder of the put if the holder exercises his right to sell. This limits the writer's risk because money or stock is already set aside.
    • But it is really not that much of a risk. The stock is not going to be purchased at the spot price; it is going to be purchased at the exercise price, which was agreed to the day of the opening transaction.

    • The higher the spot price goes, the more the writer benefits because she buys the stock at the lower exercise price and sells it for whatever she can get in the market.

    • There is a risk that the spot price will go down, but the lowest it can go is $0 and that almost never happens in the span of time covered by an options contract.

    • Let's consider the worst-case scenario, in which the writer has to pay the full exercise price for a completely worthless stock. If she sold a put at $18 and it is now worth nothing, then she has lost $18 for each share she pledged to buy: if that was a block of 50,000 shares, the loss amounts to $900,000.

    • Nobody wants to lose that kind of money, but it is insignificant compared with the astronomical losses possible with writing uncovered calls.

  • Uncovered puts are a short position in which the writer does not have cash on deposit equal to the cost to purchase the shares from the holder of the put if the holder exercises his right to sell.

    • In this case, the writer knows to the dollar, exactly what the worst-case scenario is and can make an informed decision about whether or not it is worth tying up capital to cover the put.

Option Market Regulations
Not surprisingly, there are regulations governing the market for options. You have probably heard the expression "cornering the market". This refers to what happens when a trader or a small cabal of traders decides to monopolize the supply in that market.

Options writers have tried this in the past, and that is why the exchanges have prescribed position limits, which determine how many contracts any single trader can engage in at one time.

For much the same reason, options exchanges also have exercise limits, which determine how many contracts any single trader can exercise over a given span of time.

Option Styles
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