Today we’re going to talk about rights and obligations when it comes to options.
If you’ve been a little worried and asked yourself something like this:
- Am I going to get this stock assigned to me?
- What are the legalities?
- What are the legal implications of trading these options?
This is the right post for you.
They always talk about rights and obligations. You have the right to, but you’re not obligated to.
What does it all mean?
Well, I’m going to simplify it for you.
What is Groupon and How Does it Work?
Before we get there, I’m going to use a Groupon example.
We can look up some food over here in the Groupon search bar.
What happens is you buy something – like this Groupon or in other words, a coupon.
If I want to go to Gio’s Italian restaurants, you pay $15, and you get $30 worth of Italian cuisine.
Usually, you have to buy this within a day or a couple of days. And it expires within 365 days of purchase. Think of it like there’s a time value involved there.
That’s the way that Groupon works.
What are Option Rights?
Here’s what I want to share with you when it comes to trading options. When you look at the option rights, you have to understand this concept.
You have two parts to it:
- the calls
- the puts
In there, you could be a buyer, or you could be a seller.
On the put side, you could be a buyer, and you could be a seller as well.
There are four types of legalities when it comes to options. We can look at this in terms of a Groupon.
How does it work?
Well, there are two parts here, as well. You have a buyer, and you have a seller. So, if I want to buy this Italian cuisine and I want to get this coupon, well, it cost me $15 for the coupon. But then I get $30 worth of food when I’m ready to use it. That’s the case as long as I use it within 365 days.
As a buyer, you can buy it for $15, but you get $30 worth of food. And a seller is the business owner. They have to provide or give me food. That’s the way that it works.
How does this apply to stocks or options?
Well, as a buyer, when you buy a call, you pay money. Now when you spend money, you have the right to purchase or get the stock.
- Are you obligated to spend your coupon?
- Are you obligated to go to that Italian restaurant?
Do you have to?
No, you don’t have to.
- So do you have to buy the stock if you’re a buyer of a call option?
No, you don’t have to. You can. You have the right to, but you don’t have to. You’re not obligated to, but you have the right to get that stock as long as those requirements are met here.
Let’s say a 175 call option that you bought it expires in 365 days on Netflix. Well, as long as that hit and you’re a buyer, then you have the right to get that stock if you want.
Most people don’t. They sell their option contract for more money. But you could if you wanted to.
What about the Seller?
On the other side, there is a seller.
Let’s look at it from the selling side if you’re a seller (a business owner) because you could be a seller of option premium. Just like if you’re on Groupon well, you could be a seller if your business owner.
You could sell things. Well, they’re obligated to get you the stock at that price. If the stock now is trading at $205, they have to get it at $205 and give it to you at 175.
The reason is that’s what you bought that call option for. That’s the way that it works. And on the put side, it works very similar. It’s the same concept. It’s just when you look at it on a Groupon side; there are no puts in there.
Here’s the way that you would think about this on the Groupon site.
Here you have Italian food and sushi (think of puts as sushi).
It’s the same concept. You have a buyer and a seller. And it’s the same approach.
Now it’s maybe $20, and you get $40 of food. So if you’re a buyer, what does that mean? Well, if you buy a put, you’re looking for stocks to go down. If you’re a buyer of a put, you can put that stock to someone. You have the right to put or sell the stock at a price. But do you have to get sushi? No, you don’t have to get sushi.
You could if you want to. It gives you the right here, but you don’t have to. And as a seller, now you’re obligated. Or in other words, if that stock is put to you, you’re forced.
Looking at it on a profit picture, I think that’s a simple approach to do this.
Thinkorswim Platform – Profit Pictures
Netflix right now is at 365. So let’s say I bring this down and I’m going to buy a single. So buy a call. Yes, it is 4:00 a.m.
Here’s my profit picture.
I make money as a stock goes up. In this case, I have the right to buy it if I want to at that 390. But I’m not obligated to. I could cash out as this becomes more valuable.
If I sell it, what does it look like?
Well, now I lose money as it goes to the upside right. That’s because of its opposite of the buying side.
If I do a put, how does that work?
Let’s do a put. Let’s say we have a 320 put, and I’m a buyer of it. Well, if you buy a put, you make money as stocks go down.
In this case, you’re profitable. And if you’re a seller of a put, you lose money as stocks go down. That’s because you’re forced. You could be assigned the obligation. So now what happens is you’re losing money. You have to get that the stock might be put to you.
If you’ve never seen these profit pictures before, basically, this is the profit and loss (on the left).
This is the stock price down here.
And this is what you’re making as that goes up and down.
This is what they look like.
If you’re a buyer of a call, you’re looking for stocks to go up.
If you’re a buyer of a put, you’re looking for stocks to go down.
Rights versus obligations
Well, here you have a right. You don’t have to do it.
On the put side, you have a right you got a choice to protect yourself if a stock goes down. You can give it to somebody else. But you don’t have to.
If you’re on the sell side, you have the opposite effect. Take a look at this right here. That’s a detailed version of it for you.
A buyer – you have the rights, but you’re not obligated.
A seller – hear of a call, well you have to get that stock to somebody if something is met. If you sold an option at 175, you have to get it to them at 175 if it goes against you.
On the put side, the buyer has the right to put that stock to you if you sell a put. If I sell a put at 150 while someone can put that stock to me at 150, even if that stock goes down to 100. That’s because they’ve bought that right. They’ve bought the right.
I hope that gives you a little more insight into rights and obligations and what it means.
The main thing is you have to worry about this more if you’re a seller of options and then if it goes against you.
If you’re doing spreads, you’re protecting yourself. The risk is even a little bit different; you could say it more hedged.