Options for Rookies

Exercise and Assignment. It's Still a Stumbling Block for Rookies

This post is a continuation of a previous discussion that began with this comment:

Hello Mark, appreciate your advice. As someone new to option trading, I have a fairly basic question. Let's say I am short naked SPY puts, say 105 strike price, and I shorted/sold them at $0.20. The puts are going to expire worthless and instead of buying them back, I will get assigned/or get long SPY from $104.80?

Is this correct? This would obviously seem too easy to make money. Thanks in advance.

***

My original reply can be found here:

***

Steve continued:

Thanks for the quick response. I need to read up on this stuff is my conclusion.

If the puts expire worthless (ie SPY closes above 105 at Option Exp), I will not necessarily be assigned is what you are saying? [NO.  I am saying you will NOT be assigned. Period.]

I think I understand, but I'll try...

And in Scenario 1 , I'm not assigned and I just keep my premium.

In Scenario 2, I get assigned and get long at 105, what happens to the premium? [It is is your brokerage account.  It remains there.]  Let us say I shorted the Jan SPY 105 puts at 5. And Let's say that next week SPY closes (Op/ex) at 110. If I didn't keep the premium [but you did keep the premium.  That's the basic point when selling options.  you keep the premium], does this make me break even? Do I need a close above 110 to make money in this case? [NO]

I don't want to make this more complicated, just trying to get a hold on things. I'm obviously into a situation I do not know enough about (luckily its not a losing trade).

Thanks again,

Steve

***

Steve,

My belief is that you are over-analyzing this - wanting to be certain you don't miss anything. But you did make one HUGE mistake - and lucky for you, it won't cost you anything.  You began to use options without really understanding what you were doing.  You signed an enforceable contract without reading it or having anyone explain the contract details to you.  Does that sound like the right thing to do?

I can set you straight.  You are missing some easy-to-understand information.  I am probably providing too much detail, but read this slowly.  You will get it.

1) If SPY finishes above the strike price, the chances of being assigned an exercise notice on a put option are essentially zero.  It's remotely possible that you can be assigned an exercise notice if SPY finishes at $105.01 - but that is a very, very remote possibility.

2) You may safely assume that you will never be assigned on an OTM option. 

3) This is the key: Remember the option owner has the RIGHT to exercise.  Put yourself in that person's position.  Why exercise the right to sell shares at 105 when he/she can simply sell shares in the open market - AT A HIGHER PRICE?  Exercising would be foolish.

4) Yes. 
In scenario 1, you just keep the premium.
In scenario 2, you just keep the premium.
You ALWAYS keep the premium. Period.  Always. No exceptions.

Thus, you never have to think about that premium again.  When you collect it, it is yours.

The premium is your payment for accepting the obligations that result from selling an option.  In the current scenario, you are accepting the obligation to buy SPY shares at 105 - at any time that the option owner decides to sell those shares to you (by exercising the put). You were paid $20 to accept that obligation.  Other people were paid varying amounts to accept that same obligation.

If an owner of SPY Jan 105 puts wants to exercise, he/she does not ask your permission, he issues no warning.  The option is exercised.  If your account is selected (random process) as the account that receives that exercise notice, then you must buy the shares.  There is no escape from that process.  If another account is selected, then you are not assigned that exercise notice.

If you are eventually assigned an exercise notice and want to know your cost for buying the shares, that's the time to subtract that premium from the strike price (the price you paid for the shares).  In this case, you would own the shares at a net cost to you of $104.80.  But - this may be a technicality, but this is how the world operates - you pay $105 per share, but received an earlier payment of $0.20.  Net cost: $104.80.

The premium has not 'gone' anywhere.  It is in your brokerage account.

5) This is where you are making it complicated.  You sold an option.  If you don't buy it back at some point, there are only two possibilities.  The first is that the option owner exercises and you are assigned an exercise notice.  The second is that the option expires worthless.

One other point to avoid confusion.  The identity of the person who bought your option does not matter.  All SPY Jan 105 puts are identical.  That means they are fungible. You are separated from that option buyer as soon as the trade is cleared.  That means you and the buyer are no longer connected in any way. 

You may be assigned when anyone exercises.  It's a random process and there is no need for you to know any more than that.  At least not at this point in time

If the option expires worthless, that's the end of the story.  There is nothing else you have to know about the premium or about the final closing stock price.  Nothing.  The option has expired, your obligation to buy shares has ended, and your profit equals the premium collected.  It does not change anything if you collected that $0.20 or the $5.  The option has ceased to exist.  The premium is in your account. How can it possibly matter at which price the stock closes next Friday?  The cash is in your account, no one is going to come and take it away if SPY is 109 or 111 or any other price - once the option has expired worthless. 

There are no further details to concern you.  You made a bet.  You won.   It really is just that simple.  No contingencies, no other worries.  That's it.

Try to understand these points:

You always keep the premium - no matter what else happens

If the stock (ETF) finishes above the strike, the put expires worthless

It does not matter how much the premium was; it's yours.  Remember other traders sold these puts at various times and various prices.  None of that matters.  You are all in the same boat.  The option is worthless.

It does not matter whether the stock finishes at 106, 108, 347 etc.  The put option is worthless

There is no break-even when the option expires worthless; there is only profit.  That profit is the premium you collected earlier

Please tell me you get it now.

574

Obligations and Rights of an Option Trader

As I reply to questions or visit investment forums, I repeatedly encounter option beginners who are surprised by what they discover after making option trades.

That's equivalent to paying money to enter a tournament, knowing the competition is out to take your money, and not bothering to learn the rules before getting started.

Yet it happens all the time.  Today's blog post is devoted to investors who are about to become option traders.  It's also dedicated to those who have already started, without being prepared. 

In an attempt to eliminate some of the many surprises that can occur when you don't know the ground rules, this discussion covers the rights and obligations of option traders.

Rights

Option owners acquire certain rights when they buy an option.

Option sellers have no rights.  None.

An option owner has the right to exercise the option. 

Please note that this is a right, and not an obligation. 

If you, the call or put owner don't want to exercise the option, that's perfectly acceptable.  Some rookies fear they may be required to exercise.  If that were true, no one would ever purchase a call or put option.

You can sell the option (assuming it is not so worthless that no one will pay anything for it).

You can hold it through the expiration date.  When that date arrives, if you have neither sold nor exercised the option, it expires and officially becomes worthless.

Warning:  When expiration arrives, if you own an option that is in the money (by any amount) it will automatically be exercised.  Thus, if you own such an option, and want that option to expire worthless, it's very important that you sell it - or notify your broker (immediately after the market closes on expiration Friday) 'do not exercise' those options.

Why wouldn't you want to exercise?  If you own one call option with a strike price of 30, would you pay your broker a fee of $15 for the right to buy 100 shares @ $30.02?  I hope you wouldn't.  If you want those shares, it's cheaper to buy them @ $30.02 and throw away the option.  Too many brokers charge excessive fees to exercise an option.  They also charge far too much when you are assigned an exercise notice.

Editorial comment: When expiration arrives, the powers that be - specifically the money-hungry brokers who charge a commission to exercise an option (or to be assigned an exercise notice) - convinced the rule-makers that your rights should be terminated.  Your RIGHT to exercise becomes an OBLIGATION to exercise, unless you take steps to opt out.  I have no idea why there has not been a huge class-action lawsuit against the brokerage industry for imposing this rule.

Obligations

When you sell an option, along with the cash proceeds, you become obligated to honor that contract.  Thus, if the option is exercised and your broker informs you that you have been assigned an exercise notice (this simply means that your account was randomly selected as a counterparty to someone who exercised the option), you must fulfill your commitment.  It's too late to do anything.

If assigned when short a call option, you must sell 100 shares of the underlying stock at the strike price.  You deliver the shares and receive the cash.  If you don't own the shares, then they are sold short for your account.

If assigned when short a put option, you must buy 100 shares by paying the strike price.  The shares are deposited into your account, and the cash to pay for those shares is removed.  If you don't have enough cash, your broker will lend it to you (under certain conditions).  If you cannot meet those conditions, then you receive a margin call - a very unpleasant - something to be avoided - situation.

NOTE:  You are not always going to receive an assignment notice.  Sometimes the options you sold expire worthless and your obligations are canceled.  The only way to guarantee that you are not assigned an exercise notice is to repurchase the option sold earlier.  That repurchase (buy to close) must be made prior to receiving an exercise notice.  One that notice has been received, it's too late to do anything about it.  The exercise is irrevocable and you must honor the conditions of the option contract.

It's not difficult to understand your rights and obligations as an option buyer/seller.  Please be certain you do understand them before trading.

562

Do Not Trade Index Options When You Don't Know the Rules

In response to yesterday's post about a friend you was assigned early on a 4-lot, I received a VERY disturbing reply at approximately 5PM (ET) yesterday - Thursday Dec 17. 

Here is the reply in it's entirety:

A better Christmas gift was the 22k I made today when my CTM (1055-1075 / 1125-1145) SPX IC expired OTM! 

I can understand the happiness in the anonymous (unless his name really is John Doe) comment - despite the gloating attitude.

But the fact that John believes his options have expired makes me very upset.  How can this happen?  How can anyone have so much money at risk and not understand the rules of the game?

Here's my reply:

***

John Doe,

You are under a VERY serious misconception.

1) Your CTM spread is still CTM.  And will remain that way until after the market opens today.  Today is expiration Friday (technically the options expiration date is tomorrow) and today is the day that the final SPX closing price for the December expiration cycle is determined.

2) I agree that your position seems reasonable and the chances that your options will indeed expire worthless are decent.  But your options have not expired; the settlement price for SPX has yet to be determined; and it is still possible to lose the maximum amount, or $2,000 per iron condor.

3) Settlement price (symbol = SET) is calculated from TODAY'S opening price for each of the 500 stocks in the index.  When each of the 500 opening prices is known, then SET is calculated as if each stock were trading at its opening price at the same time.  In other words, SET is not a real price.  You never see an SPX quote at that price.  But it's the ONLY SPX value that is used to determine which options are in, at, or out of the money.

If you get a quiet opening, you will come out okay.  If the market gaps, you will not immediately know your fate.

4) That calculated price, SET, will not be announced until approximately 1PM ET tomorrow.  Many times, bewildered, inexperienced index option traders believe they have escaped unscathed, only to discover they have a large loss resulting from a Friday morning gap. 

SET is OFTEN much higher or lower than the opening SPX print.

5) I hardly consider this to be a Christmas gift. To me, you are taking an incredible risk.  And what makes that so terrible is that you have no idea your options are still very much alive. 

How can you trade without knowing how European style options are settled? How is that possible?  Did you know that you were trading European options?

I don't know if I am more upset with you, your broker, or the world of options education that allows you to play the game when you don't know the rules.

At Options for Rookies, I've posted about this problem and its importance.

***

Having vented my frustration at I know not whom, John posted another comment assuring me that he knows what he is doing.  And I'm sure he does.  He was merely a bit premature with the expiration.  I see no reason to cancel my comments, so they remain as a warning to others.

***

ADDENDUM:  All's well that end's well, but I still find the play too risky for me.  Congratulations to John Doe on his winning trade.

554

An Early Christmas Present: Being Assigned an Exercise Notice

One of the characteristics that describes being a rookie (at anything) is the anticipation - more accurately, the concern - that something unexpected will happen and that whatever it is, it's going to be bad news. 

The rookie often worries about, or anticipates, problems that don't exist.  Don't misunderstand.  It's fine to think about potential problems and know how to deal with any that may arise.  That's a significant part of the learning process.

The problem (as I see it) is that being reassured that 'it' is not a problem is often insufficient to alleviate those concerns

Case in point:  Early exercise.

Based on the questions I receive, one of the topics that seems to be of major concern to the rookie option trader is the possibility of receiving an assignment notice prior to expiration.  I always reply that it's nothing that need concern you - unless it triggers a margin call from your broker. 

Another example:

When visiting online forums, I sometimes run into people who have another misconception: that it's impossible to be assigned an exercise notice on an option that is out of the money.  I have no idea why anyone would believe that.  An option owner has the right to exercise at any time, for any reason, prior to expiration.  I'm not suggesting that anyone ought to expect to receive an assignment notice on such OTM options, but the possibility exists.

This morning (Dec 16), a friend of mine had an interesting experience  and I want to share it with you.  More than that, this is a real-life situation that may alleviate some of the concerns that trouble rookies.

He had sold 10 KR (Kroger) Dec 20 puts and to eliminate all risk, was bidding $0.05 to cover the short position.

The previous day's closing price was $20.16, and his bid for the puts went unfilled.

This morning, he received an exercise notice on FOUR of these OUT OF THE MONEY puts.  

My friend received an early holiday gift.  Not only did he not have to pay the nickel to cover his short puts, but he was paid an extra premium for closing the position!   By selling 400 shares at the opening of trading today, he collected extra cash ($17 for each of the four options).  Sure, he had to pay a commission - but it was well worth it.  

Too bad it was only a four-lot, but no one is complaining.  Except for the investor who exercised those options. 

I'd love to have the ability to find that investor and ask why the options were exercised.  But that's impossible. 

I have a theory:

The investor's broker alerted him/her to the fact that the position was in the account and would soon expire (probably resulting in a margin call, if exercised).  That inexperienced trader took that 'alert' as a warning to exit the position.  And, as too many innocent option rookies do, had no idea that selling the puts was the correct path. 

Not knowing what else to do, perhaps our novice exercised the options to get rid of the puts.  That would be a shame and a costly experience, but it's the best rationale I have for the exercise.

553

Exercising, trading, and investing with options II

This is Part II.  (Part I)

Questions/comments from Scott:

One of the quotes I wrote down from the Options Clearing Corporation states “we usually see options exercised early if the option holder is able to buy below parity."

Years ago, when I was a market maker, whenever I sold stock short, I collected interest on the cash generated.  One reason that was a wonderful benefit can be seen when I was able to buy a call option near parity.  I would then sell stock short and have a put that was better than free.  I would earn more in interest than I had to pay in time premium.  Thus, I was guaranteed a profit - just from the interest.  And, if the stock ever fell below the strike of the call, that would be even better.  The stock drops in value and the calls moves to worthless.  An opportunity for extra profit as the stock falls farther.  This position, long call, short stock is equivalent to a put.  And to get it for free was just great.

Thus, if I bought that call, I would never exercise before expiration.  I'd keep the free put.

The world is different today.  I don't know if anyone collects interest on short stock, but I doubt it.  In fact, many have to pay interest when they borrow shares to sell short.  No matter.  The point is this:  If a market maker can buy calls under parity and then sell stock, there is nothing to be gained by holding the position when it is deep ITM.  The free put doesn't have much value and if paying interest to own the position, it's better to get rid of the position and take the profit.

Example:  Stock is $80.  Buy the Nov 60 call, paying $19.90.  Sell stock short at $80, exercise the call and collect the free profit of $10, less commissions.  It's these professional traders who occasionally get to buy puts and calls below parity.  These are the traders who hedge with stock and then exercise.

This has nothing do to with you or any other individual investor.  It's virtually impossible for you to buy options under parity and take advantage of this.  But where this affects you is being certain that you do not misinterpret that line from the OCC as a suggestion that exercising such calls is beneficial to you.  Unless there is a dividend you want to collect (and often it does not pay to collect it), do not exercise any call option prior to expiration.  That's essentially true for puts also, but there is an exception (You own DITM puts and stock.  By exercising you eliminate position and save the cost to carry.  But you are giving up the upside profit opportunity if stock rallies above strike).

***

Do you have a plan to earn a profit when you buy out of the money calls? What are the details of that plan?

Of course I plan to earn a profit—as to the details of the plan, that is the purpose for reading books and asking questions.

I was referring to the details of the plan.  Most, dare I say all?, traders in your shoes buy OTM options and sell them at some point.  Holding to expiration kills all the time premium you paid, and that makes it even more difficult to earn a profit.  If that's your plan (holding to the end and exercising) that's truly not a good plan.  If you are a stock trader, why not be an options trader instead of becoming an options investor?

***

In hindsight, this was not a very good example. I’ll try again: In August I wrote down the options chain for AIB. The stock was selling for $5.25. The premium on the SEP 5 was $0.45. In mid-September AIB broke $9.50 and I could have sold the OCT 10 option for $1.15. Shortly after, AIB fell below $6.00.

Would it have been better to exercise the option or to sell it?

If I exercised the option and sold the shares I would have made ($9.50-$5.45 X 100) = $405 per contract.If I had resold the option I would have made ($1.15 X 100 – original premium of $45) = $70 per contract.

Is the math right?

It would have been better to sell it.Yes, the math is correct.

But you were describing the sale of the Oct 10 call at $1.15.  You want to sell the Oct 5 call, which was obviously trading at a much higher price.  The price would have been at least $4.50 (parity), and perhaps a bit higher.

Suggestion: For clarity it's better to refer to the Oct 5 call, rather than the 'Oct 5 option.'

***

(Describing a put option that is in the money by $5 per share) ...But once again, just sell your option, collecting $5 for the same profit. Why exercise?

What if the option premium is less than $5? 

That's one time to exercise the option and sell the shares.  Although the bid for an option can be under parity, it only happens when the option is deep in the money.

***

Please, do yourself a big favor. Get a copy of The Rookie's Guide to Options. Read it. All the details are there to help you understand what you are doing when trading options.

I do plan to get a copy of your book.

***

Once again, thank you for the time and thought you put into your replies—it is greatly appreciated.

Scott,

Thanks Scott.  When the questions are thoughtful, I'm very happy to do it.  You clearly know what you are doing as a trader - but options are still new to you and learning the answers does not come from osmosis.  You are making the effort, and that's what it takes.

Good trading.

513

Q & A. Exercising, trading, and investing with options

Scott is continuing a conversation begun earlier. 

Below, he has clarified some questions and raised new points that are worth discussing.  Link to the above post to read the entire discussion from the beginning.

Mark,

I appreciate the time you took to respond to my questions - questions that after rereading the following day I realized were poorly written. And in reference to a few of your comments, no, I have not begun trading options with real money—thanks for your concern. I’ve done well trading stocks and thought it time to learn about options.

***

Below are pertinent excerpts and my replies.  Scott's comments and questions are in bold.

***

1) Is your understanding that you can always earn a profit when buying options?

No; I’ve read that more than 75% of options expire unexercised.

The figure about options going unexercised (expiring worthless) is false and misleading.

That 75% (I usually see a higher estimate) number refers ONLY to those options which are still open when expiration arrives.  Many - dare I say most? - of the options that have value - have already been closed.  That means the original option buyer may have taken a profit or loss, but he/she is unlikely to continue to own that option all the way to expiration.  This applies to the sellers as well.  Those closed option trades are ignored by those who publicize the statistic you quote.  This results in too many people believing the incorrect numbers.

Example: If the open interest is 100, and 80 are closed prior to expiration, that leaves 20.  If 15 expire worthless, the figure you see as expiring worthless is 75%, not 15%.  The 75% is a statistical lie.

***

I have a question for you: Why are you mentioning the idea that you 'could exercise' the option? Did you 'learn' that exercising is a reasonable choice?

In each source that I’ve read they spend equal amounts of time discussing the two choices available if the underlying stock advances past the strike price: 1) resell the option for a slight profit, or 2) exercise the option and either sell or hold the stock. From what I understand, the second option seems to be more advantageous if my plan is to purchase and own the stock in the long run. With this choice, if I am right I may able to purchase the stock at a slight discount and if I’m wrong and the price plummets, I am only out the price I paid for the option.

Most call buyers do NOT want to exercise a call option and take possession of the shares for the longer term.  They prefer to trade the options and earn a profit (or take a loss when necessary).  That doesn't mean choosing to exercise is wrong for you, but think about the cost.

Consider this:  You can buy stock today at 28. Or you can pay a premium to buy a 3-month call option with a strike price of 30.

If you buy the call, your downside loss is very limited.  And that's good.  But, if you are considering exercising the option if it moves past the strike price (and remains there until it's time to exercise), It seems to me that your choice comes down to paying $28 today, or $30 (plus the option cost) later.

There has to be a very good reason why you would not want to pay the reduced price today.  One such reason for taking this stance is that you are not going to be bullish on this stock unless it breaks out by trading above 30.  You are buying the option because you expect it to rally very quickly once it breaks out.  And if it never does that, you don't want to own the shares.

Most investors who plan to exercise a call and take possession of stock would benefit by buying ITM, not OTM options.  Yes, you can lose more if the stock declines, but if it's your intention to become a shareholder, the purchase price matters.

One more point. I don't consider buying an out of the money option and later exercising - to be buying the stock at a discount.  It may be a discount to the price at the time you exercise, but you paid dearly by not buying stock today.  This is paying more for the stock than you should be paying.

These are the major reasons that option buyers are not usually interested in buying (or shorting) the shares.  Option buyers tend to trade for profits.

Bottom line: Decide why you are buying the options and the best way to achieve that goal, while paying attention to risk.

***

When you own an option, you have the 'right' to exercise. But more importantly, you have the right NOT TO EXERCISE. So once again, I ask, why are you considering exercising the option? Did you read that exercising is to your advantage?

Several sources mention that most options are exercised when they are in-the-money by $0.05 or greater, especially if the buyer believes the underlying stock will continue to rise.

Those sources are referring to what happens when expiration arrives.  When discussing exercise choices, omitting that detail is criminal, in my opinion.   Almost all options that are in the money (ITM) by one penny or more are exercised - at expiration.  Not before.  Occasionally an investor may elect not to exercise an option that is barely ITM.

But the point is:  They are referring to expiration, and only expiration.

to be continued...

512

Q & A. The exercise decision. It's not complicated. Part II

Questions from Scott. Part II. Part I.

3. If a strike price is in-the-money at the time of option purchase, is it possible to exercise the option at any time? For instance, SRZ last traded for $4.28 and has a November strike of NOV 2.5. It has an ask of $2.15 for a break-even of $4.65.

Any option on an individual stock can be exercised at any time. No exceptions. 

The language of options: A 'strike price' is never 'in the money.'  Only the option is in- at- or out-of the money.  

Let's look at your example.  Why would you want to exercise that option?  Never exercise an option that has time premium in it's price.  Do you know what time premium is?  It's the money you immediately lose when exercising an option.

If you pay $215 and then exercise, your total cost is $4.65.  When you immediately sell the stock, collecting $4.28, you have a loss - plus you paid commissions for the privilege of taking that loss.  Do not do this.  If you wait until the stock is $4.65, you still have no profit. 

Your profit potential comes from selling the option at price higher than you paid - not from exercising the call option.

***

4. In theory, I could buy a put option for $1 a share on a stock trading at $24 with a strike price of $24. If the stock dropped to $19, I could then exercise the put option with the right to sell it at $24 per share for a $5 per share profit, minus premiums. Is this correct? Who would buy the stock at $24 a share?

An option is a contract.  There is a legal requirement that the parties to a contract honor their obligations.

When someone sells an option, that person is paid a cash premium.  Do you think the option buyer pays that cash premium just for the fun of paying?  Not a chance.

The seller accepts certain obligations in return for collecting the cash premium and in your example, is obligated to buy the shares at $24 if and when that person is assigned an exercise notice.  The seller can't say 'I changed my mind.'  Nor can he say 'I'm not buying.  Try to force me.'  There's none of that childish stuff.  This is business.  It's a legal contract.

When assigned an exercise notice on a put option, the option seller's broker places the stock into that person's account and withdraws $2,400 per option to pay for the stock.  It's done overnight and the option seller is notified the next morning.  It's a done deal.  It cannot be reversed. 

But once again, just sell your option, collecting $5 for the same $400 profit.  Why exercise?

It's shocking to me that you are considering using real money when you lack an understanding of how options work.  Please, do yourself a big favor.  Get a copy of The Rookie's Guide to Options. Read it.  All the details are there to help you understand what you are doing when trading options.

***

5. What is the difference between a put and a naked/uncovered put? Is it true that in both options, you do not own the underlying stock?

The owner of an option is never considered to be 'uncovered.'  That term is used only for options sellers.

A 'naked' or uncovered option means the option seller does not have an offsetting position in the shares. 

Thus, a naked put is a put sold by an investor who is not SHORT 100 shares of stock for each option sold.

When you sell a put option it does not matter whether you are LONG the stock.  If you are not SHORT stock, then you are uncovered.

A naked call is a call option sold by an investor who is not LONG 100 shares of the underlying stock for each call sold.

When assigned an exercise notice, if the investor has the shares in his/her account to offset the exercise, then the option was covered.  If there are no shares, or not enough shares, then the option is naked or uncovered.

***

6. If you sell a put and the stock drops and is assigned to you, do you have to maintain sufficient cash to cover the stock purchase at or below the strike price until the option is exercised by the buyer or expires?

Once the option is assigned to you, you OWN the stock.  You already paid for it (past tense) as soon as you were assigned that exercise notice.  You do not need any additional cash, but you must have enough cash to have paid for the stock. Or, as an alternative, you can borrow the cash from your broker if you have enough assets.

***

Thanks for all of your help!

Scott

Scott.  You raised important points.  But points that everyone must understand before trading options.  If you appreciate the replies, please answer my questions. The information will help me better understand the misinformation being generated.

490

Q & A. The exercise decision. It's not complicated. Part I

Today's questions come from Scott.  He clearly wants to understand the options game.  And I recognize that it can be confusing.  

Scott has made an effort to acquire knowledge, but unfortunately the source of that knowledge has endangered his ability to use options profitably.  I hope these blog posts clarify these important points.  And if anyone else is under any of these misconceptions, I'd like to hear from you.  My task is to help you begin (or continue) trading options with the probability of success on your side.

Scott, I am presenting your letter in it's entirety (in two parts) in an effort to correct any misinformation already in your head and to find out where you 'learned' about options.  Scott, I would truly appreciate hearing from you again.  I directed some questions to you in my reply below.

***

Mark,

1. I have read that it is possible to be right about the direction of the stock and the timing and still lose money at expiration. Can you give me an example? 

My understanding is that I could exercise the call option or sell the option for a profit.

Here's an example:

AAPL is $205.  Believing the stock will move higher, you buy the Nov 210 call, paying $4.

You are correct.  When expiration arrives, AAPL has rallied to 209.  Your option expires worthless, and you lose $400.

Perhaps you are even more correct.  The stock slowly rises to 213 (Price corrected 10/24) and closes at that price on expiration Friday.  Your option is worth $300 and you paid $400.  A $100 loss.

Is your understanding that you can always earn a profit?  If that is what you believe, forget it.  When you buy options you will lose money more than half the time.  The goal is to have enough large gains to offset the frequent losses.

I have a question for you:  Why are you mentioning the idea that you 'could exercise' the option?  Did you 'learn' that exercising is a reasonable choice?

Addendum:  Any time that the option is trading at a price that is higher than the price you paid you can sell the option for a profit.  In this respect trading options is exactly like trading stock.

***

2. If I am correct about the direction and timing of a stock and the option/stock is out-of-the-money by several points, I could exercise the option, sell the stock, and keep the profits. Do I have to have sufficient funds in my account while the option is active in order to buy it at the strike price? Hypothetically, I could control $2500 of stock for $500 worth of options. Does this mean I have to set aside $3000 ($500 for the premium and $2500 in case the stock reaches the strike price) until exercise or expiration

This question frightens me to the core. I hope you have not yet begun trading options with real money.

a) If you own a call option that is out of the money, do you understand what that means?  It means that the stock is trading BELOW the strike price.

Under those conditions, no one in his/her right mind would exercise an option.  Look at it this way.  You own GOOG Nov 560 calls and the stock is $557.  You have a choice.  You can buy shares at $557 in the open market, or you can exercise your right to pay $560.

Which do you think is a better idea?  I hope you understand that $557 is the only reasonable answer.

When you own an option, you have the 'right' to exercise.  But more importantly, you have the right NOT TO EXERCISE.  So once again, I ask (Scott, I truly want to know the answer to this question.  Please tell me.), why are you considering exercising the option?  Did you read that exercising is to your advantage? 

Let me assure you that an option owner should almost never exercise.  Yes, there are exceptions, but for someone who is speculating by buying options - as you are doing - just forget about exercising, and sell the option when you no longer want to own it.  But I still want to know where you got the idea about exercising.

One more point: The stock is never in or out of the money.  Those terms apply only to the option.

b) You cannot 'keep the profits' in your scenario. There are no profits.  Only losses.  And the losses will be much larger than they should be - if you choose to exercise an out of the money option.

Look at it this way:  You bought the option.  It doesn't matter what you paid, but you paid more than zero.

Next you (using my example) buy GOOG at the strike price (560) and immediately sell it at a lower price (because the option is out of the money; 557 in this example). 

You lose the cost of the option and you also lose $300.  There are no profits. 

Scott: I want to understand this.  I have had many questions along these lines.  You are not alone.  Where did you find the idea to exercise out of the money options?

c) No.  You are not required to maintain any cash in your account.  There is no reason to exercise the option. NONE.  If you do choose to exercise, you still do not need to have cash in your account.  You may borrow the necessary cash from your broker, provided you have sufficient assets - that means other marginable investments.

If you have such assets, your broker will lend you up to fifty cents on the dollar to make other investments.  This is known as margin.  If you lack those assets and exercise the options, you will receive a margin call.  You will be forced to sell the shares (I know you wanted to do this anyway, but this time you have violated security laws.  An investor is not supposed to meet a margin call by liquidating positions.  Assets should be deposited into the account). No prison terms, but there may be limitations placed on your account. 

Some brokers prevent clients from exercising when it produces a margin call.

But, save yourself all these worries.  Do not exercise.  Do not think of exercising.  Sell the options when you want to exit the trade.

d) "in case the stock reaches the strike price"

It sounds to me as if you intend to exercise the option when the stock reaches the strike.  Is that true?  I must know: where did you get this idea?  I am pleading with you to help me find out from whence this bad advice is coming.  It must be stopped.  This simple idea is costing innocent investors thousands and thousands of dollars.  Please help me find the source.

Here's a simple way to understand that the idea of exercising when the stock 'reaches the strike price' is a very bad idea.  Compare two trading strategies:

1) Investor one wants to buy stock when it rises to $60 per share.  He believes that is a technical breakout and will get long at that price.  He enters an order with his broker to buy shares, if and only if, it trades as high as $60.

2) Investor two buys a Nov 60 call option, paying a premium of $2 per share, or $200.  If the stock never trades as high as $60, the $200 is lost. He then buys the Dec 60 call option, paying $2.10.  The stock hit's the $60 target and he immediately exercises the call.

Compare: 

Investor one pays $60 for stock.  If the stock doesn't trade at $60, he loses nothing.

Investor two (that's you) pays $64.10 for the same stock.  Is that a good idea?  If the stock never reaches $60, you lose $200 in Nov and another $210 in Dec.  This cannot be what you want to accomplish when buying options?  [Scott:  Do you have a plan to earn a profit when you buy out of the money calls?  What are the details of that plan?]

I hope you can see that exercising an option when it hits the strike is a terrible waste of money.  And it frightens me that anyone would consider doing this.

to be continued...

489

Q & A. Must I buy those 'worthess' options

I'm adding an extra post today because I believe this is an important issue.  Especially on expiration day.

***

A Rookie Question: I sold 4 GOOG 560 Oct expiring naked calls recently, and now its going to come down quite a bit today. I think  it might get down to 0.10 or even 0.00 (as long as GOOG does not go above 560. Do I still have to buy it back?

What if at the end of the day GOOG stays about $558 and I still get assigned with the option. I will have to come up with $400X558 (whatever that is) to give this person his shares. Can someone do that? I mean can someone ask for buying the shares although the market value of the shares is below the strike.

Lets say I wanted to buy GOOG on Friday and didn't get filled. An on Sat I thought well...lets just get it through the guy who sold me the call option at $560. In that case I will have to find a lot of money and buy shares and give him that.

Could this be possible? ....Am I making any sense BTW!

***

Good morning.

Have to buy it back? You NEVER have to buy it back. You are allowed to let the options expire worthless. But be warned, some brokers will force you to buy the options today. They do not allow any customers to own a position that can result in a margin call - due to an exercise. You would have to ask your broker if you are allowed to watch the options expire worthless.

If you are truly a rookie, why are you selling naked call options? Why does your broker allow that? It's a pretty risky strategy. GOOG is up to the mid 540s before the market opens, and the market futures are lower.

If this market turns around - and I am not saying it will - GOOG could easily run past $560. Far higher.

It may be a 'waste' of money, but I would certainly pay $0.05 or $0.10 to get those options out of your account.

My guess is that the price will be higher early in the day, but if you want to buy them - enter an order now, before the market opens. a LIMIT order, never a market order.

If you don't want to 'waste' the money, you are NOT obligated to buy them

NO. You are not buying the stock, and don't need cash. You need assets to meet the margin requirement. You would have a short position of 400 shares. I'm sure you cannot meet the margin requirement for that, and your broker will force you to buy the stock on Monday. Why take that risk. Who knows what the price will be at that time.

There is almost zero possibility that you will be assigned if GOOG is less than $559.99. Buy yes, someone can do that. The call owner has the RIGHT to buy the stock at any time prior to expiration. The actual stock price determines whether the call owner will elect to buy the stock at the strike price. But, no one can prevent the person from exercising. It's his/her option and you have no voice in determining if/when the option will be exercised.

Yes, you are making sense. But, Saturday is too late to exercise the option. This afternoon is the deadline.

Don't take this wrong: If you do not understand how this works, if you don't understand the risks you are taking when you sold those options, why did you make this trade? This is important: Please understand all the risk and reward potential for any trade BEFORE you get involved. It is not a trivial matter.

484

Q & A. When to Exercise. Is it Really a Diffficult Concept?

I receive more questions of the topic of when the owner of a call option may want to exercise that option than on any other topic.  This is a very basic part of options trading, and it's mandatory to recognize when and why an option owner would want exercise an option. 

Is this really such a difficult concept to grasp?

Mark,

I'm a beginner. If I were writing an in-the-money covered call, would the strike price need to be reached before the buyer would call away the stock shares?

Thanks for your help.

Alex S.

***

Alex,

When you write an in the money covered call, the strike price has already been 'reached.'  The stock is higher than the strike price. That's why it's called an in the money call option

That fact, all by itself, is enough to tell you that seeing the stock 'reach' the strike price is an insufficient reason for the call owner to exercise the option and 'call away' the shares.  How do you know that?  Because investors are willing to pay a price higher than the intrinsic value of the call option.  No one in his/her right mind would pay a premium above intrinsic value and then throw away that premium by immediately [the buyer may want to exercise weeks or months later, but NOT NOW] exercising.  Here's an example:

You own shares of YZX which is currently trading at $52 per share.  You sell some YZX 50 call options (expiration date is immaterial) and collect $350 for each.

NOTE: These options are 2 points in the money.  That means the stock is $2 higher than the strike price, and thus, the intrinsic value of the option is $2 per share. The time premium  [total premium minus intrinsic value] is $1.50 per share, or $150 per call.

Let's look at this from the perspective of the call buyer.  He/she had these choices:

a) Buy stock, paying $52 per share.

b) Buy YZX call options with a strike price of 50, paying $3.50 per share.  Hold the options until it's time to do something with them.

c) Buy YZX call options with a strike price of 50, paying $3.50 per share.  Immediately exercise the option to take delivery of the shares.

Your question suggests there is a possibility that the call owner may want to select (c).  If he/she exercises, it costs $50 per share to own stock.  Add to that the $3.50 per share paid for the option, and the cost is $53.50 per share.

Why would anyone want to pay $53.50 (plus extra commissions) to buy stock that is available at $52?  Answer:  No one would do that.  It's possible, but unlikely, that it may be appropriate to exercise the calls at a later time.  But that is a totally separate discussion and unrelated to your question.

You must understand why an investor will NOT exercise.  Do not consider making a single option trade until you know for sure that the buyer of a call option is not going to exercise when the stock reaches the strike price.

Therefore, no one is going to exercise the call options (the ones you sold), just because the stock reaches the strike price.  You will not receive an exercise notice and you will not be obligated to sell your shares [of course, if the call owner blunders, it is possible to be assigned that exercise notice.  Just don't expect it to happen in your lifetime.]  That's true no matter how high the stock moves.  Any call owner who no longer wants to own those options gets rid of the position by selling the options - not by exercising.

If the option owner were to exercise the option when the stock hits the strike price, that would be a bad blunder.  You never exercise an option when it has time premium remaining (that means any time it is trading at a price higher than the intrinsic value of the option). There are other, very important reasons for not exercising, but you must understand this one before thinking about other reasons: you want to comprehend the basics before moving on.

***

If you meant to ask about an out of the money covered call, the same principle holds true.  The call owner will nave NO reason to exercise any earlier than necessary (expiration).

The following is a very minor oversimplification and there are a couple of exceptions, but in general you can take the following statement as gospel:

IT IS ALMOST ALWAYS WRONG FOR ANYONE TO EXERCISE A CALL OPTION PRIOR TO EXPIRATION.

434

Avoiding Early Assignment

This video states that 'it costs you nothing' to short stock.  Be aware that some brokers charge a fee when you hold a short stock position - and if the stock is difficult to borrow, the fee can be very stiff.

410

Being Assigned an Exerice Notice; Any Problems?

Yesterday's post discussed what happens when you are assigned an exercise notice.  My premise is that it's seldom a problem.  I'd appreciate hearing some of your experiences to see if my perception of the world agrees with your experiences:

[I'm still trying to find the right polling website to use.  If you have suggestions, or if you want to elaborate on replies, please comment.]

Click Here for PollOnline Survey
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View MicroPoll

Q & A. Trading Options: Exercise and Assignment

Via email: "Would like more on the perils of assignment."

One of the recurring topics I encounter is a  new option trader's concern about being assigned an exercise notice on some option he/she has sold.

There are situations in which being assigned results in an unhappy ending, but they are few are far between.

Let's begin with simple definitions for option rookies:

Exercise: The process by which an option owner does what the option contract allows.  The call owner buys 100 shares of the underlying asset by paying the strike price. [NOTE: if the option is European style, the call owner may only exercise when expiration arrives and receives the intrinsic value of the option, in cash]

Assignment: The process by which an investor who has a short position (the option has been sold, but not yet expired or repurchased) in a specific option is notified by his/her broker that the OCC (Options Clearing Corporation) has issued an assignment notice and that the broker has designated the investor's account (randomly selected) to receive that notice.  The investor is now required to fulfill the conditions of the option contract by selling (if it is a call) or buying (if it is a put option) 100 shares of the underlying asset at the strike price.  The assignment notice is irrevocable.

If you have a position and receive such a notice, what can go wrong?  All that has happened to you is that an option has been converted to stock.  Unless you are trading in a small account and receive a margin call, you are now in better shape (risk-wise) than you were before being assigned.

If you wrote a covered call, the position has been closed, you earned the maximum possible profit from the trade and you received cash that allows you to make a new trade.

If you wrote a naked put, you now own the shares you were willing to buy when you sold the put.  No harm done, if you truly want to own the shares.

If you have a complex position, an option with 100 delta has been removed from your account and been replaced with stock.  If there are no margin problems, then this position has a better risk profile than you had before you were assigned.  I don't want to take the space for the details, but look at it this way:  If short a call, all you make on a decline is the call premium.  But if you are short stock as the result of an assignment, and the stock tumbles below the strike price, you earn more than you could have earned before.  In effect, the option you sold is now trading at less than zero.  How can that be bad for you?

There is one very troublesome situation, and that occurs when you sell American style index options.  That applies only to OEX options, so to avoid this problem, don't trade OEX options (they are ok to purchase if you are an option buyer, but don't sell them). A detailed explanation of why this type of assignment can cause problems is presented in this Investopedia article.

408

Q and A. Can OTM Options Be Exercised?

Hi Mark

I trade options by selling them and all this while I've been unaware that out of the money options could be exercised. A friend of mine recently told me that it's possible, although not probable. Is it true? I have always thought by definition, if an option is out of the money, it cannot be exercised and hence, I have always tried to let my out of the money options expire worthless as much as possible. Would greatly appreciate any kind of info you could provide. Thanks very much!

Just an addendum, I could see a scenario like this being profitable the end of the day of the last Friday before options expiration and a stock suddenly spikes after hours to be in the money...
Leo

***

Hello Leo,

Yes, it's true. The owner of an option has the right to exercise an option at any time before it expires. The fact that it's out of the money does not cancel that right.

Although you did not ask, when selling options, I believe that allowing options to expire worthless is far, far riskier than many believe - especially because there is so little to gain.  Of course, if you sell options at low prices (I shudder at the thought), then paying a few pennies to close those positions won't work. But, if you receive a decent premium, then surely you can afford to pay a nickel or dime to cover - especially when there are several weeks remaining before the options expire. Why take any risk for such small potential profits?

Getting back to your question, consider this scenario:
A market maker has a hedged position and is long 50 Jul 40 calls and short 5,000 shares. It's late in the afternoon on expiration Friday and the stock is trading at 40.00. Our MM wants to buy 5,000 shares to cover his short, and decides to bid 39.97. Time passes, the stock trades as low as 39.98, but our MM buys zero shares. The stock closes at $39.98.

The MM has two choices:

• Do nothing, and go home for the weekend short 5,000 shares

• Exercise those out of the money calls, and go home flat, with zero risk

Which do you think the MM will choose?  The decision is easy.  He exercises.  Of course, he can try to pay $39.98 in any after hours trading before exercising.  But he doesn't have much time.

Thus, it's very reasonable for OTM options occasionally to be exercised.  There is no guarantee of not being assigned an exercise notice just because the option appears to be worthless.

As to your addendum, that's also a risk when you allow an option that you sold to expire worthless.  The problem is that most individual investors will be unaware of that after hours spike, and will not exercise their options.  Remember they officially finished out of the money.  But you can be certain that the professional traders will be aware of the news, and exercise.

It's very simple to exercise after hours , but the time window is short.  Each broker has its own cutoff time, but all the exerciser has to do is notify the broker "Do exercise these options."

315

Exercising An Option. Is It a Good Idea? Part II

(Part I)

There are two more good reasons for not exercising an option earlier than necessary [NOTE:  This information is for investors who own options because only the owner has the right to exercise.  The seller has no rights and has nothing to say concerning the exercise of an option.]

1) Cost.  This is a minor but not insignificant reason.  When you exercise an option and convert it into a long (call option) or short (put option) stock position, many brokers charge a fee for exercising the option.  If your plan is to get rid of that stock position, there is no reason to pay that exercise fee.  Simply sell your option instead.

If your plan is to exercise a call, then you acquire stock (by paying the strike price), and it costs real cash - the interest paid to own the shares.  What's your hurry?  Why pay interest?  Exercise at the last possible moment - and that's when expiration arrives.  And it's an automated process.  There's nothing for you to do because exercise is automatic when the option is in the money at expiration.

Unless you have a good reason, it's usually better to sell the option, rather than exercise.

2) Risk. It's time to discuss the primary reason why early exercise of an option is a serious mistake.

When you own an option, you have limited risk.  The most you can lose is the cash you paid to buy the option.  But, once you exercise that option, your risk increases significantly.  It's true that if the option is deep in the money, then that risk is minimal.  But for some reason, too many novice investors believe it's a good idea to exercise an option as soon as it moves into the money.  I hope the discussion in Part I convinced you that this is a very bad idea.

Assuming you understand how to avoid that trap, let's look at a situation in which you own the ZZX Jul 80 call, for which you paid $2, and decide to exercise the option one week prior to expiration when the stock is trading at 84.

Example, Thursday morning of expiration week

Original position: Long one ZZX Jul 80 call, current value: $450

Post-exercise: Long 100 shares of ZZX, current value: $8400.

ZZX is suddenly in the news. The company pre-announces that earnings are going to be lower than anticipated.  On that news, the stock opens for trading at $70 per share.

If you still owned the call option, it would become worthless and your original $200 investment would be lost. 

If you now own stock (for which you paid $80 per share to exercise, plus $2 per share you paid for the call option), you loss is $12 per share, or $1,200.

By exercising, you placed yourself in jeopardy - and in this example, something bad happened.  Sure it was unexpected, but you had nothing to gain by exercising and the market punished you (by $1,000 per option) for making that mistake. 

Let's hope this example remains hypothetical and you understand why early exercise is not a good idea.

Early assignment

Many investors fear being assigned an exercise notice.  It's nothing to fear.  In fact, it can sometimes be a gift.  Suppose you had written a July 80 covered call on ZZX and were assigned when the stock was 84. 

Congratulations.  You sold your stock at 80 and the investor who exercised early saved you from a 10-point loss.  Early assignment does not occur often, and most of the time it doesn't make any difference.  But occasionally, it's a gift.  So please don't fear it - look forward to the possibility.

170

Exercising An Option. Is It a Good Idea?

NOTE:  Several corrections were made to the earlier version.

One of the basic properties of an option is that it represents the right to buy (call option) or sell (put option) at the strike price at any time before the option expires.

There is no obligation to exercise, and the owner of an option has other choices:  the option may be sold, exercised, or allowed to expire worthless.

Despite what I thought was an easy-to-understand principle concerning the stock option, visitors to this blog have asked basic questions in recent days - demonstrating that they do not clearly understand the exercise process.

For those who posted questions, and others who may also be uncertain about how to make a decision when the possibility of exercising an option presents itself, I've decided to dedicate today's entry to the topic of 'exercising an option - is it a good idea?

*****

Terminology

The owner of an option has certain rights and may exercise those rights any time before the option expires.

The seller of an option has certain obligations and may be assigned an exercise notice at any time before the option expires.  Notification that the option has been assigned to you occurs before the market opens on the next business day, following the exercise of the option.  Once assigned, the terms of the option contract must be fulfilled. 


Guidelines

1) If you sold an option and don't know when to expect to be notified that an exercise notice has been assigned to you, the simple answer is not to expect to receive that notice prior to expiration.  There are occasional exceptions, but it's not common.

2) If you sold an option and want to tell the option owner to exercise because you want to be assigned, forget it.  The option seller has no rights and must wait.  Only the option owner has the right to decide if and when to exercise.

3) When an option is exercised, the option itself is canceled, and may not be used again.  Instead of owning a call option, the call exerciser now owns 100 shares of the underlying stock (or ETF), for which he/she paid the 'strike price' per share. 

The put exerciser is now short 100 shares of the underlying asset, for which he/she received the strike price per share.

4) When assigned, the investor who was short that option, is no longer short the option (because it was canceled).  Instead, the assignee is now long 100 shares (If assigned on a put option) or short 100 shares (if assigned on a call* option).  The stock transaction occurred at the strike price.            *corrected

5) If you sell an option and want to be certain you are not assigned an exercise notice, the only way to do that is to repurchase the option.

6) Let's now look at this process from the point of view of an option owner.  Let's say you buy a Dec 35 call option when the stock is 32.  You pay $200 for the call. 

Three weeks prior to expiration, the stock rallies to $35.  The call is now trading at $3.50.  What should you do?

Some investors believe it is right to exercise the call option.   That is a huge mistake.  Why?

a) By exercising you are paying $35 for stock.  If you wanted to own stock, why did you by an option instead of stock?  There are good reasons for owning an option (see below), so it is foolhardy to exercise.

b) The option is worth $350.  If you sell the option, you collect that cash and (in this example) earn a profit.  If you exercise the option, it is canceled and the $350 in time premium is lost.  All you own now is 100 shares of stock for which you paid $35.  You never want to cancel an option that has time premium remaining.

c) What is time premium?  The price of an option has two components: the time value plus the intrinsic value.  The intrinsic value is the amount by which an option is in the money.  Or, it's the amount by which the stock price exceeds the strike price of a call (or is below he strike price of a put).
For example, if the stock is $38.15, then the intrinsic value of your Dec 35 call is $3.15 per share, or $315.

Subtract that $315 from the option price (premium).  With the stock trading at $38.15, the option premium depends on many factors, but let's assume it's $4.50.  To determine the 'time premium' in the option, subtract $315 from $450.  In this example, it's $135.  Whenever you exercise an option, you lose the entire time premium (but you keep the intrinsic value).  Why?  Because the option is canceled and turns into stock.  That stock is worth $3,815 and you paid $3,500 (plus an additional $200 for the option).  That's a net profit to you of $115. 

If you sell the stock, you collect $3,815.  But, if you had sold the option instead, you would have collected (in this example) $450.

Your choice:  Earn a profit of $115 by exercising (and paying an extra exercise fee and another commission to sell stock), or earn a profit of $250 and pay only one commission to sell the call option.  Easy choice.  Do not exercise.  Sell (or continue to hold) the call.

This is important.  if you are an option rookie, be certain this principle is clear to you.  If uncertain what to do, it's almost always better to sell the option than exercise.  There are exceptions, but this is not an appropriate time to discuss those exceptions.

There are other reasons not to exercise an option earlier than necessary.

to be continued...

168

Option Education; Please Don't Trade Without It

I received a follow-up question to yesterday's blog post and I believe it's a good idea to share it, because it demonstrates how easily rookies can get a wrong idea into their heads - and that idea can result in major headaches and lots of lost money.

My job is to help you understand how options work so you can avoid making these mistakes.

***

Mark,

Once again, thanks for answering my questions. I can't think of a better blog than this one. As a follow-up my previous question:

There is one thing I’m still confused about though, and that is the actual exercising of the options.

From what I understand, once my option is in-the-money, after I’ve exercised the option, the only thing that happens is the shares are delivered into my account.[And the cash to pay for those shares is removed if it's a call option; or the cash is deposited if it's a put option.] I’ve either taken a long or a short position. After that, I still have to sell or buy the shares in order to make a profit. That means that I have to be watching the bid (long position) and the ask price (short position) of the underlying stock immediately after exercising to make sure that those values are still higher or lower than the strike price of the option.

If the above is true, and I am correct, what is the lag time between the time that I exercise the options and when they are actually delivered into my account?  If the lag time is long enough, the stock price could have easily changed by the time I can actually buy or sell them. In other words, isn’t it possible that they would no longer be in-the-money by the time they are delivered?

Mike

***

Mike,

Exercising is very simple. You are making too much of it.

1) It's usually a bad idea for an individual investor to exercise an option. The easiest and most efficient method for closing the option position is to sell it. There is seldom a good reason to exercise.

However, you may exercise if you so choose.

2) Most of the time an option is exercised when expiration arrives. In that case, the stock is in your account Monday, before the market opens. That means you can sell long stock, or cover your short stock position by buying it.  [As an aside, the stock doesn't have to be in your account to sell it.  You can sell it short.]

3) If you decide to exercise an option prior to expiration, you must submit instructions to your broker. Nowadays that's done online. But some brokers accept such instructions over the telephone.

The instant you submit those irrevocable exercise instructions to your broker, you own the stock. Don't worry about when the shares are delivered to your account. Ignore the fact that stock trades take three days to settle. The moment you exercise, you own the shares and can sell them.

There is no 'lag time for delivery.'  None.

4) It seems to me that you are under the FALSE impression that you are supposed to exercise your options as soon as they move into the money. That's a very bad idea. I don't know why you  believe that to be true. But, I've been asked before if it's appropriate to exercise when an option moves into the money. Someone, somewhere must be dispensing the opinion that one should. Don't do it.  Otherwise I have no idea why investors come to this conclusion on their own.

There are so many things wrong with exercising under these conditions that I simply don't know where to begin.

a) The fact that you are concerned about when the stock will be delivered so you can buy or sell it should already tell you that you don't want to put yourself in that awkward position.

b) Sell the option and save yourself all the trouble.  Why worry about 'watching the bid and ask?'  Why worry about the price you are going to get when trading the stock?  Sell the option and your position is closed.  If you sell for more than you paid, you have a profit.

c) To reply to that last question: Yes, there is a chance the stock will move above or beyond the strike price immediately after you exercise. But that's only a problem if you exercise. No one is forcing you to do so. In fact, it's much better if you simply hold onto your option. Exception: if it's late in the day on the 3rd Friday of the month, it's time to give up and simply sell the option.

d) Have you ever heard of 'time premium?'  Do you understand how options are priced?  the value of an option equals the time premium plus the intrinsic value (if there is any).

If you own a call option with a 40 strike price and the stock is 42, depending on how much time remains before expiration, the call may be price at $3.50. If you exercise, paying $40 for stock and then immediately sell the stock at $42, you have $200 in cash and no remaining position.

If you sell the call, you collect $350 in cash, with no position.

Which would you rather have: $200 or $350?

If you exercise the option you SACRIFICE all remaining time premium. You don't want to do that.

5) You made the statement that, after exercising, you must keep watching the stock to see whether it is above or below the strike price. Why place yourself in such a position?

If you DON"T EXERCISE and continue to hold the option, two good things happen. First, you still own the option and can exercise (or sell) it at a later date. You have lost nothing. Second, when you hold an option, all you can lose is the value of the option. That's why people pay money to buy options: limited risk. But, once you exercise, you own stock. Nothing good can happen as a result. Nothing. But something terrible can happen.

In my example above, if the stock falls to 32, your call option becomes worthless and you lose the $350 you could have earned by selling. But if you exercised (sacrificing that $150 in time premium) and the stock declines to 32, you lose $800 (you paid the strike price per share, or 40, and it's now 8 points lower) - and that's more than you could possibly lose by holding the option.  Nothing to gain, lots to lose. 

So why would you want to exercise? You MUST understand this simple concept or you cannot trade options. You have to understand how an option is valued to prevent you from throwing time premium into the trash. You never want to convert a limited risk position into an unlimited risk position. This is a very basic concept and if you cannot grasp this, you are not yet ready to trade. That's okay. you have the rest of your life to trade. This is your education time.

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I take option education seriously, and am telling you that there are certain prerequisites to trading options, and you are simply not ready.

Exercising OTM Options

Here's an unusual question I received last night.

Mark

As I have learned, 1 (one) stock option contract gives me the right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock at a specific price during a specified period of time.

Let’s say that in October I decide to purchase 1000 “far out-of-the money” Microsoft call options for 1 dollar apiece at a $25 strike price (Microsoft October 25 calls). The total premium is $1000. [Note: "One dollar apiece means the option price is $0.01 and the cost is $1 per contract.]

But, since each contract is worth 100 shares, those contracts are technically worth 100,000 shares of stock. After several weeks, it becomes fairly clear that my strike price isn’t going to get hit—the stock has been trading steadily at $23. However, I still have the right to exercise the options at $25.

In the above scenario, I decide to exercise all 1000 of my options regardless of the fact that they are not in-the-money. Isn’t the seller still required to deliver 100,000 shares? If so, that would mean that 100,000 shares would still be taken from his account and put in my account. I now have 100,000 Microsoft shares in my account, at which point it’s up to me to sell them on the open market. Do I have this correct?

1) Yes, you have the right to exercise those 1,000 call options.

2) Your broker may interfere, telling you that you have made an error.  Thus, if you truly want to exercise, you must be certain your broker knows (use the telephone) your desires and does not automatically stop the exercise from happening.

3) No, the 'seller' is not required to deliver anything.  The Options Clearing Corporation (OCC) randomly chooses, from among all brokers who have accounts that are short that option,  one broker and assigns that broker an exercise notice.

Next that broker using one of two methods: random selection or oldest position first, assigns that exercise notice to one of his account holders.  Assuming this account is not short 1,000 of these calls, a 2nd, 3rd etc. account is chosen to receive an exercise notice. That continues until all 1,000 contracts are assigned.

If that broker's customers, in the aggregate, are not short 1,000 contracts (the OCC knows the exact number when it begins the process), then the next randomly chosen broker is assigned an exercise notice.  The process continues until all assignments have been accounted for.

It's possible that the original seller will be assigned, but with a very large open interest, more likely he/she will not be assigned.

4) Yes, you would have 100,000 shares of MSFT in your account, but there is no way to know the source of those shares.  Your original $1,000 investment has now cost you $2,500,000 (that money went to the various investors who received those assignment notices, $2,500 for each option assigned).  If you cannot meet the margin requirement, you will be forced to sell some, or all of those shares.

5) Yes, it's your decision.  If you meet the margin requirement, you may hold the shares or sell them.  It's your choice.  But, if you cannot meet the margin call, it's no longer 'up to you,' because your broker will force you to sell.

***

NOTE:  Although I have never seen options exercised when they were $2 out of the money, don't be surprised if you are occasionally assigned when an option is only a penny or two out of the money.

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Being Assigned an Exercise Notice: No Big Deal

Surfing online forums, I frequently encounter questions from option sellers who are extremely concerned about being assigned an exercise notice on an option they sold.  Usually these questions come from newcomers to the options world.

When an option owner exercises his/her rights and elects to buy (by exercising a call option) or sell (by exercising a put option) stock at the strike price, someone (randomly chosen) who currently holds a short position in that option is assigned an exercise notice and must honor the conditions of the option contract.

Receiving an exercise notice should not be a problem, unless one of two different conditions obtains.

• You are underfunded and being forced to buy or sell stock, as the result of an assignment, results in a margin call.

• You are trading OEX options.  These options are cash-settled and American style, and being assigned on these presents so much potential risk that I recommend not trading OEX options.

When assigned an exercise notice on a call option, you simply sell 100 shares of stock (or an ETF - exchange traded fund).  Your upside risk is unchanged.  Your downside risk has improved. Why? If the stock eventually falls below the strike price at which you were assigned, you earn extra profits.

Example:  You have some spread position in which you are short one XZZ Nov 60 call.  Two weeks prior to expiration, XZZ is trading near $75 per share, the call is trading near $15, and someone (makes a mistake) and exercises the call and you are assigned.  You are no longer short the call.  Instead, you must [CORRECTION] SELL 100 shares at the strike price.

You have lost nothing.  You repurchase the call at zero (gaining $1,500 compared with the value of this option yesterday) and sell stock at $60 (losing the same $1,500 compared with yesterday's closing stock price). 

But look what happens if the stock issues bad news prior to expiration.  If the stock falls to $52, the call is worthless and you would have gained the original premium.  Instead, you buy back the stock by paying $52 - not only collecting that option premium, but also earning an additional $800 profit - that you could not have earned if you were still short the call.  In other words, it's as if you repurchased the call option and collected an $800 bonus for buying it.

Consider the unfortunate option exerciser.  Had he/she not exercised, he/she would have lost $1,500 (from the day of the exercise).  Instead, he/she lost $2,300 when the stock moved from 75 to 52.

Being assigned early is nothing to fear.

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Assignment Notice: Who Receives It?

A newcomer to the options world received an exercise notice from her broker and wanted to know how that was possible when expiration was still three days away.

For those who don’t understand the exercise/assignment process, here’s a brief outline:

1. An option owner may exercise an American style option at any time before it expires.

a. All options on individual stocks are American style.

b. Some index options are European style and may not be exercised before expiration.

2. When an option owner exercises an option, his or her broker notifies the Options Clearing Corporation (OCC).

3. The OCC randomly chooses a clearing member (such as a broker) and assigns an exercise notice to that member.

4. Each broker has its own methodology for choosing which of its customer accounts receives that exercise notice. To be eligible to receive an assignment notice, the account must have a short position in that specific option. The assigned firm must use an exchange-approved method (either a random process or the "first-in, first-out" method) to allocate those notices.

It’s not a conspiracy. The process is fair to all parties.

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Exercising an Option: Who's in charge?

Important note: There is one major misconception that is fairly common among option rookies. It leads to a great deal of confusion and I want to be certain that it never happens to you. This discussion is important enough to justify its own blog entry.

· The owner of an option has certain rights.

· The seller of an option has NO rights.

 

· Only the owner of an option can exercise that option.

· The owner of an option is NOT obligated to exercise, but has the right to do so.

 

· The owner of an option has three choices:

o Sell the option.

o Exercise the option.

o Allow the option to expire worthless.

 

· The seller of an option has only two choices:

o Repurchase the option sold earlier – but it must be repurchased before the seller is assigned an exercise notice. That removes the option from your portfolio and cancels all obligations.

o Wait for expiration to learn whether you have been assigned an exercise notice.

§ That notification arrives before the market opens for trading on the business day following expiration.

§ Most brokers provide that information on Sunday, following expiration. But only for online accounts.

 

· The decision to exercise rests entirely with the option owner.

· The option seller may not request that the option be exercised.

· The option seller may not ask the option owner ‘please do not exercise’.

· Once the option is exercised and the option seller is assigned an exercise notice, the transaction is final. It cannot be undone.

 

· Automatic exercise:

o If an option is in the money by one penny or more, it is automatically exercised.

§ The ‘closing price’ of the underlying stock that determines whether an option qualifies for automatic exercise is the last tick on the primary exchange on which the stock trades (usually the NYSE or NASDAQ) on the last day that the option trades (almost always the 3^rd Friday of the month).

§ If the stock moves above or below the strike price AFTER the market closes on expiration Friday, that price change is ignored for the purposes of the automatic exercise rule.

 

o Option owners:

§ May submit instructions to their brokers, telling them “do not exercise.” This is a reasonable action when the option is only in the money by a penny or two.

§ Each broker has its own rules and cutoff time for submitting such a notice. Be certain you are aware of your broker’s requirements.

§ May submit instructions to their brokers telling them DO exercise, even when the option is out of the money. This does not happen often, but it does happen.

 

o Option sellers:

§ May not request that an option be exercised.

§ May not request than an option not be exercised.

§ Have no rights. None.

Bottom line: If you sell options, such as in covered call writing, you have no say in the decision to exercise that option.

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Warning about the exercise process

Over the past few years, I have been asked the following questions:

· I own an option that is out of the money. Must I exercise it?

· I don’t have the necessary cash in my account to pay for stock. Do I have to exercise my call option?

· My broker tells me that I have no choice and must exercise my call option. I don’t want to do it. Was I given bad advice by my broker?

 

For some reason that I don’t understand, many rookies find themselves asking a similar question. Let’s be sure each of you understands this basic point:

*The owner of a call option has the right, but not the obligation, to take action specified in the option contract. That means the call owner may, if he decides to do so, exercise the option and buy 100 shares of stock at the strike price. But, there is no obligation to do so. The option owner may sell the option at any time before it stops trading on Expiration Friday. The owner of an option may allow the option to expire worthless.

*The owner of a put option has the right, but not the obligation, to take action specified in the option contract. That means the put owner may, if she decides to do so, exercise the option and sell 100 shares of stock at the strike price. But, there is no obligation to do so. The option owner may sell the option at any time before it stops trading on Expiration Friday. The owner of an option may allow the option to expire worthless.

To repeat – you are never obligated to exercise your option. It’s your choice. That’s why it’s called an option.

NEW RULE CHANGE

However, please be aware of a new rule that was adopted by the option exchanges and the Options Clearing Corporation: Effective with expiration in June 2008, any option that is in the money when expiration arrives – even if it’s in the money by only one penny – will be automatically exercised for you. In other words, your rights – the rights you were guaranteed when you bought the option – have been revoked. I find this to be outrageous and totally unacceptable. But sadly, my opinion doesn’t count.

To protect yourself from this problem, if you are unable to sell your option and you don’t want to exercise, it’s now necessary to notify your broker – shortly after the market closes on expiration Friday – that you DO NOT want to exercise. If you fail to notify them, the option will be exercised. Take the precaution of being certain you know how to deliver that ‘do not exercise’ instruction in case you ever need it. Ask your broker now  how to notify them.

Why is this such a problem? If the stock is trading at $50.01, shouldn’t you want to buy it at $50.00? No, you shouldn’t. For one thing your broker probably charges a fat fee to exercise. If you pay $15 to exercise an option that’s in the money by one cent, you are already $14 worse off than before you exercised. And now you own the stock (if it’s a call option) and probably want to sell it. That costs another commission.

This rule change is definitely a money-maker for the brokers, but a money loser for their customers – and that’s you, the individual investor. If I were you, I’d complain bitterly to your individual brokers that this rule is totally unfair. But, it’s probably tilting at windmills and nothing will change.

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