EXERCISE DEFINED
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Here is where exercise should be more thoroughly explained.
When you buy an option, whether it is a put or a call,
you are buying a right to exercise. When we say exercise with regard
to a call option, we mean to call from the writer
(seller/backer) of the option the 100 shares of stock as specified
in the option at the specified option strike price. The writer is required
to deliver that 100 shares of the stock at specified strike
price to the buyer if the option is exercised by the buyer.
With regard to a put option, we mean to put (sell) to the
writer of the option the 100 shares of stock as specified in the option
at the specified option strike price. The writer is required to
buy that 100 shares of stock at the specified strike price from the
option buyer if the option is exercised by the buyer. The writer
who is being exercised is being assigned the obligation to deliver
or buy the stock randomly by the Options Clearing Corporation.
Therefore, the process of exercise is called assignment.
Spread Designer
THE DEBIT SPREAD
The debit spread is a way to buy an option at a lower price.
The disadvantage is that you limit your profits. To design a limited
risk debit spread, follow these steps:
1. Select an option you wish to buy, i.e. IBM Jan 70 call at 3.
2. Select an option you wish to sell in the same month but
make sure it is out-of-the-money by 2.5, 5, 10 or more
points, i.e. IBM Jan 75 call at 1.
3. Subtract the price of the option you have sold from the
option you have bought, i.e. Jan 75 call at 1 from Jan 70
call at 3, and your total cost would be 2.
4. The result is the cost of the spread and your maximum
risk.
5. The maximum gain can be measured by subtracting the
cost of the spread from the maximum possible gain
(which is the difference between the strike prices of the
spread; i.e. 70–75 is a 5 point spread.) Using the IBM example,
you will see that 75–70 is the spread, and the cost
of the spread is 2, so the maximum gain is 3.
6. To evaluate a spread, you need to look at the maximum
possible percent return and the probability of making a
profit and making the maximum return. In our example,
the maximum return for the IBM 70–75 spread would be
150% (300/200= 150%). A probability calculator can be
used to measure your probability of achieving such returns.
With the IBM spread, IBM must close above 75 at
expiration to achieve a maximum return.
Here is where exercise should be more thoroughly explained.
When you buy an option, whether it is a put or a call,
you are buying a right to exercise. When we say exercise with regard
to a call option, we mean to call from the writer
(seller/backer) of the option the 100 shares of stock as specified
in the option at the specified option strike price. The writer is required
to deliver that 100 shares of the stock at specified strike
price to the buyer if the option is exercised by the buyer.
With regard to a put option, we mean to put (sell) to the
writer of the option the 100 shares of stock as specified in the option
at the specified option strike price. The writer is required to
buy that 100 shares of stock at the specified strike price from the
option buyer if the option is exercised by the buyer. The writer
who is being exercised is being assigned the obligation to deliver
or buy the stock randomly by the Options Clearing Corporation.
Therefore, the process of exercise is called assignment.
Spread Designer
THE DEBIT SPREAD
The debit spread is a way to buy an option at a lower price.
The disadvantage is that you limit your profits. To design a limited
risk debit spread, follow these steps:
1. Select an option you wish to buy, i.e. IBM Jan 70 call at 3.
2. Select an option you wish to sell in the same month but
make sure it is out-of-the-money by 2.5, 5, 10 or more
points, i.e. IBM Jan 75 call at 1.
3. Subtract the price of the option you have sold from the
option you have bought, i.e. Jan 75 call at 1 from Jan 70
call at 3, and your total cost would be 2.
4. The result is the cost of the spread and your maximum
risk.
5. The maximum gain can be measured by subtracting the
cost of the spread from the maximum possible gain
(which is the difference between the strike prices of the
spread; i.e. 70–75 is a 5 point spread.) Using the IBM example,
you will see that 75–70 is the spread, and the cost
of the spread is 2, so the maximum gain is 3.
6. To evaluate a spread, you need to look at the maximum
possible percent return and the probability of making a
profit and making the maximum return. In our example,
the maximum return for the IBM 70–75 spread would be
150% (300/200= 150%). A probability calculator can be
used to measure your probability of achieving such returns.
With the IBM spread, IBM must close above 75 at
expiration to achieve a maximum return.