Selling Covered Calls/Puts Explanation - Real Life Examples
So these are contracts if I sell a put to someone I have the obligation to purchase the stock. So my question is exactly how does everything happen. Say John writes a $35 strike price Jan 2014 put on Ford in the public markets. Who keeps the put - as in who's on the opposite side of the trade making the contract with you - because doesn't it matter?
Scenario 1) Say John sells this put on the public market and Bob buys it. The stock falls to 25 on December 31st. However Bob forgets that he even made this agreement and is out of the country and can't access his computer until February. He never exercises his put option rights and John just pockets the premium?
Scenario 2) John sells this put and Jim the hedge fund manager buys it. Stock falls to 20 in November and can't find a floor. Bob wants Jim to execute his put rights but he can't. So what can he do? I know he can buy the same put back at but its at a higher price and the spread is huge, he would rather buy the stock since? What other choices does John have?
You have to check the specification of the contract on the appropriate website. For example, options on the SPX index will settle into cash, whereas options on SPY will settle into SPY stock, and options on oil may settle into futures.
Most options you see on stocks will be auto-exercised into that stock. So even if Bob is away from the computer and does not do anything after buying the put, he will get short the stock at expiration. (Your brokerage firm will have additional rules regarding margin etc)
In scenario 2, I assume you mean "John" (not Bob), the guy who sold the put wants to get out of his position. In that case, he can either sell shares, or buy the same put back, or buy a different strike put back to limit his losses. The bid-ask spread of both the stock and option are risks inherent to making the trade in the first place, but a.stock like Ford is going to be pretty tight and liquid for the common investor.
So when you write a put, does that contract stay in your portfolio? Same scenario. Ford become $50 in december. Can you gain any of the upside (buy your put back or something) or is your upside limit capped to your premium.
And I don't get the mechanics of writing a put and buying it back. Because say you write a put and you're in agreement with Person A but you want to buy that put back. Don't you buy it back from the public markets not Person A? So how does that "negative" the written put?
Yes, your maximum upside when writing an option is the premium of that option (you are hoping it expires worthless). So if you write a $35 put for $3, it doesn't matter if the stock is $35, $50, or $75 at expiration, you will still only make $3. Look up payout diagrams for a put and call.
For every buyer there must be a seller. So the number of position of puts that are long = number short. Look up what open interest means.
It doesn't matter who's on the other side, since it's the exchange which matches buyers and sellers is on the other side.
In general, you might want to read a nice options book, which talks about these things in some detail.
Read Natenberg - Options Pricing and Volatility
Thanks does this book talk about the mechanics behind the options market?
Also any recommendation on learning about the mechanics of equity markets? For example how the NASDAQ/NYSE really works - when you place a order , the details of how everything gets routed, the market makers, ECNs etc...
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