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Trading Traps for the Unwary II

Continuing yesterday’s horror stories, Tristan submitted another:

Something doesn’t seem right about this. I was short the 115-116 call spread in SPY 55 times during March expiration. I was assigned on the 115 call (the short part of my spread) on Thursday after the close (found out Friday morning). This resulted in being short 5,500 shares on Friday morning versus my long 55 116 calls. On Saturday, I was debited from my account a significant charge because I was short the shares when SPY went ex-dividend on that Friday.

Am I responsible for the entire dividend payment for that quarter because I was short the stock on that one day of ex? Seems like stealing. I feel like if I had bought the stock that day, there is no way I would have gotten credit for an entire quarter of a dividend payment. Anyone know how this works?

***

“Anyone know how this works?” This is the stuff that drives me nuts. If you don’t know how it works, why are you trading a product where it is essential that you understand how it works?

Dividends are paid on specified dates. Whoever is short on that ex-dividend date pays the dividend. Whoever owns the shares collects. Very simple, very efficient and it has always been this way. It’s also fair and reasonable – for owners of the shares. When the stock (or ETF) pays a dividend, the stock price declines by that amount. Gain the dividend, lose in the share price. No one gains or loses.

Alas, it’s not so simple for option owners. When you own an ITM call option that should be exercised to collect the dividend – WARNING: NOT ALL ITM OPTIONS SHOULD BE EXERCISED FOR THE DIVIDEND – failure to exercise results in a real monetary loss. The trader who submitted the question above did not know about the dividend, did not know he should have exercised his calls, and donated his money to some lucky trader who had been short those SPY 116 calls.

To reply to the comment: You are correct. If you bought shares that day (Friday) you would NOT get any of the dividend. You would be too late by one day.

I do agree with the lamenter’s opening thought. There is something not ‘right’ about this situation. What’s wrong is that you should not yet be trading options because your education is far too incomplete.

More Questions from Tristan

For instance, what to do if long puts are automatically assigned upon expiration

If you know in advance that you cannot meet the margin requirement, then do not allow yourself to be assigned at expiration. BUY THEM BACK before expiration. There is no solution that’s any easier. If you are not short the options, then you cannot be assigned an exercise notice.

or if short legs are assigned in spreads

There is almost never any reason to be assigned earlier than expiration (other than exercising a call option to collect the dividend). However, this is a recurring problem for SPY options. It ALWAYS goes ex-dividend on the third Friday of the month. Not knowing that – in advance – is just a huge mistake. If you fear being assigned on any position, then the answer is very simple (Honest. This is a deadly serious situation) Answer: Get out of the trade. Do not hold to expiration. Ask yourself why would you decide to hold to the bitter end? It is so unnecessary. For goodness sake, get out when you may be assigned and especially when you cannot meet the margin call.

If you are assigned on one leg of a spread, and if margin is not a problem, keep the position. Someone handed you a gift, and if the stock makes a big move (down if you were assigned on a call option or up if you were assigned on a put option) then you will score a nice big payday. It’s unlikely, but it has happened before and will happen again.

However, if you are unable to hold the trade and must liquidate, do not decide to exercise your long option to get out of the position – unless this option has zero time premium. It is more efficient to buy back the short stock and sell your long calls [Or sell your long stock and sell your long puts].

as well as simpler topics such as bid/ask spreads, order types, conditional orders , orders I should place in advance . in case I temporarily go into a coma through expiration, the Pattern Day Trader classification, the same-day substitution rule, Regulation T, etc.

There is a lot of stuff on your list. The truth is that most people have no need to understand most items on the list. That raises the question that concerns you: Why are people allowed to trade when they don’t understand the rules? And how do you know what it that you must know when there is no one to provide a list.

The answer to the first question is easy. They are allowed to trade because it is profitable for the brokers. Nothing else matters.

There’s not much that the average trader can do about the items on your list. If he/she becomes a pattern day trader (not a common situation), that’s when he/she will learn about those trading limitations.

Most beginners have no need for conditional orders and have plenty of time to learn how to use them.

However, bid/ask spreads and limit orders are essential items. I assume that anyone who teaches options classes or writes books for beginners includes that information. Traders who jump right in with no education may have some painful experiences when entering market orders. Not everyone can be protected. Would you open an account and enter orders with no advance study or preparation? Of course not and there is no protection for those who do.

You have one advantage. You are aware that dangers exist, and although you may not ask every question, you will be frightened enough to ask questions about any situation that occurs to you. That may not be enough – but you would have to be very unlucky to not have discovered what you need to know when you aware that you don’t know what it is that you don’t know.

Some answers

Don’t pay the offer; don’t sell the bid.

Never never never use a market order. Limit orders only.

There is no need for fancy order types. Limit orders and stops (I don’t like stops for option traders) should be sufficient.

Buy back shorts when they get very cheap – just in case you do temporarily go into a coma through expiration.

The Pattern Day Trader classification is not a concern, unless you day trade. And if you do, you will soon learn the limits.

You can get much of this information from your broker. But get it in writing. The people in customer service may be as bad as your correspondent found them to be (yesterday)

The CBOE stories scare the living daylights out of me — I wonder what these traders were supposed to have read to understand/avoid those problems in the first place. It is not asking too much to know when a stock/ETF you are trading goes ex-dividend.

It really seems like trading was designed for people who have a Series 7 broker’s license and know all these nuances.

I understand how you feel. The bottom line is that people are trading – and they intentionally did not bother to learn the rules. They make bad assumptions and get stuck with the bill. When you sell a call option, you must know that the owner is allowed to exercise at any time prior to expiration. It seems to be a natural question to ask – why would anyone exercise early? That’s when the trader would learn bout dividends.

You may be frightened, but it seems to me that you are taking care to learn about lurking dangers.

928

No one is forced to trade. Information is available to everyone.

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Lessons for the Options Beginner

The following short video was prepared to explain a simple options concept:

Why option owners elect NOT to exercise an option prior to expiration

This is the type of ‘extra’; that occasionally will be available at the new (launching April 1, 2011) Options for Rookies Premium website.

Exercising a Call Option: Don’t Do It

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Exercise and Assignment: Rookie Mistakes

Certain questions never go away

I suppose that’s true because there are always new people beginning to undertake the study of options. Those rookies ask the same questions that many of us raised when we were just getting started.

Today I’m reviewing some of the most basic aspects of options, and am offering a short explanation as to why they are true. One note of caution: This post is for beginners, and if something is true 99.999% of the time, this is not the place to discuss the rare exceptions

These items all relate to the exercise/assignment process.

Let’s begin with a question submitted to Tyler at his blog (Tyler’s Trading).

1) “I know the probability of being assigned before expiration – while there is still time value left in the option – is very slim, but is there still a chance?”

The option owner has the right to exercise that option at any time prior to expiration. That means that anything is possible and that option owners can make mistakes. However, it is best to assume that any option with any time premium will NOT be exercised. Sure, you may get that surprise assignment once or twice over the years, but not often enough to give it much thought.

In fact, when assigned on a (covered) call option with remaining premium, consider it a gift when you can repurchase the stock and re-sell the call. Or, you may prefer to get an early start and sell an option that does not expire in the front month. That gives you that extra premium as a gift (as long as it’s more than enough to cover trading expenses). That is capitalizing on someone’s mistake.

This gift happens more often than anyone would suspect, especially before a dividend. Traders who should know better, exercise an option – just to collect the dividend – and then have downside risk that is far to large for the reward. And the person assigned the exercise notice takes the gift, buys stock and re-sells that option, thereby collecting a premium that is larger than the dividend.

2) Why it’s so very wrong to exercise a call option any earlier than necessary (when puts are very deep ITM, it’s reasonable to exercise the put. This is more true when interest rates are higher.)

When you own a call option, all you can lose is the value of the call. That’s one reason traders may prefer to own calls, rather than stock. The call owner pays a premium in time value when buying the call. Exercising cancels all remaining time value. Why would anyone throw away that time value? Once you exercise, you own stock and can get clobbered when the stock price tumbles. Not exercising costs nothing. The call owner participates in upside movement, and there is ZERO reason to accept all that downside risk in exchange for NOTHING. Early exercise of a call option is a very bad idea.

The one exception (worth discussing now) is that it may pay to exercise early to collect a dividend. Much of the time, it’s still wrong to make this exercise. Do it only when there is ZERO time premium in the option and its delta is 100.

3) For reasons that astound me, some rookies believe that the call owner always exercises when the stock rises and hits the strike price of the option. If you among the tiny minority who believe this is true, let me assure you that it is not. Not only does exercising destroy the large time value in the option (time value reaches its maximum when the option is at the money), but the entire cost of the option is wasted. All the trader had to do instead was place a buy stop order to buy shares if and when the stock hit the strike.

That costs zero and the option is far from free. Even better, if the stock never hits that target buy price, the trader loses zero while the option owner sees his investment become worthless.

Many mistakes are unavoidable as we grow as traders. However, there is no reason to make either of the mistakes listed above.

903
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Understanding Option Basics

In this post I painstakingly explain one of the most basic option basics to a reader who is having trouble understanding that concept.

Mark,

Here is my follow-up question (original Q &A are here):

Jeff,
I am here to help you understand how options work, but am at a loss as to where to begin. I’ll explain in the simplest possible language. I am not talking down to you. I am trying to get you to move past a mental block.

FACTS

1) Any time that an option is in the money (ITM) at expiration, expect that its owner will exercise. Even when it’s ITM by one penny.

2)The option owner must fill out and submit a DO NOT EXERCISE form to prevent the Options Clearing Corporation from exercising ITM options

Many beginners do not know they have the choice to not exercise

Many beginners forget they own the options or forget that expiration has arrived. As a result, they become owners of stock that they do not want, and cannot afford to purchase

Many beginners make mistakes. Let’s minimize yours.

***

Call strike price + premium paid = break-even

I’ve placed your equation in bold. It is of vital importance that you understand one thing about that equation:

    This equation, all by itself, is the cause of your problems

. Forget it. It has no relevance on whether anyone exercises an option. Your formula is fine for keeping records, after the trade is closed. It is unimportant now. More than that. It is currently causing confusion and limits your ability to recognize the truth.

Using such a formula, does it follow that when the stock price is less than the break-even, then the call would not be exercised? For example, if at expiration the stock was $15.05 and one had purchased the $15 strike for a $0.10 premium, it seems one would not exercise the option.

No, it does not follow. If you ignored your break-even equation, you would never ask this question. You believe the owner of your call option would throw away $5, just because it represents a loss! Look at it from the perspective of someone who owns 100 calls. They are worth $500 to the trader.

You are saying that it ‘seems right’ for trader would throw away $500 because he paid $1,000 for that investment. No one in his right mind would do that.

To clarify: Have you ever sold stock at a loss? Did you consider telling your broker to take the shares out of your account and to give them to some randomly chosen person? Instead of taking current value for your stock, you could have chosen to make them worthless to yourself. Surely you know not to do that. When taking a loss, you recover some money. Your money. This situation is no different.

You must not toss cash in the trash just because the trade is at less than break-even.

If you lost a $10 bill and the next day found a $5 bill, would you refuse to pick it up because your loss was a larger sum? This is exactly the same. You must understand this principle. I don’t know how to make it more clear. Those options are worth $5 apiece and only an idiot would elect not to collect cash for them. [Exercise is a different decision and trust me when I tell you that selling is better for you.] Whoever ends up holding those options will exercise at expiration.

There is a tiny [my guess is less than one chance in 10 million] that an option ITM by five cents would not be exercised by its owner. But, it remains a possibility. People do make mistakes.

Yet I have read that options will be exercised if the stock price exceeds the strike price at expiration [MDW: this is only true for calls; for puts the stock must be below the strike], which it does in my example. It makes me wonder if there are other factors being considered by the call buyer. One rule, which I assume is adopted by the industry, is that all options in the money at expiration by $0.05 or more are automatically exercised, unless otherwise directed. What other factors could cause calls to be exercised below the break-even detailed above?

Yes, automatically exercised. The OCC does not care about break-even. Nor should you. Today the number is ITM by $0.01, not $0.05.

You want to know what other factors would make someone exercise when that exercise (or sale) results in a loss. Here’s the answer: MONEY.

When you invest or trade, it is inevitable that you will have losses. When you have a loss, you do not have to lose every penny. The trader is allowed to sell (or exercise) to recover some money. You probably understand that process. However, when expiration comes into the picture, you ignore what you know because you think about that break-even nonsense. When you fail to exercise (or sell), you allow the option to expire WORTHLESS. Why would you take zero for an option that you can sell for $0.05? Answer that one question (correctly) and you will understand.

How can the original cost matter? That’s your hang-up. That break-even is bothering you. Today, right now, you have a choice. Take $5 or take zero. It’s as simple as that.

Perhaps my question was misunderstood. I discussed selling the call rather than at what stock price a call owner will exercise. I understand and agree with you that it is better to sell your call for any amount rather than let it expire. I also understand what you mean by saying the premium paid is meaningless. Yes, if your plan was to sell the call and not exercise it then the premium paid is meaningless in terms of deciding whether you are going to sell the call or let it expire.[MDW: If you understand that, then why are you asking?]

(However, the premium is not meaningless if you want to determine if your trading strategy is successful as it represents part of your investment.)

I did not misunderstand. The premium is meaningless, as you admit.

You continue to look at useless items. You think record keeping and evaluating your strategy play a role in this discussion. They play no role when it’s time to make a trade decision. They are used after the fact to see how well you did. [If you disagree, and I have no doubt that you do, that discussion is for another time]

Also, I think you misunderstood my example when I said the stock price was $15.05 and I had a call with a $15 strike for which I paid $0.10. This was interpreted as the stock was trading at $15.10. Perhaps the price relationships I used in my example would not exist in the market. I apologize if I improperly set my example.

When you buy the call at ten cents, and eventually exercise, then you buy the stock at the strike price ($15) per share, but your cost basis is $15.10. You did not improperly set your example. Nor did I misunderstand.

Even so, I am encouraged by how you ended your response: “In this scenario you should almost never want to exercise”. This indicates to me that the risk of owning the stock, plus the additional investment required, must produce a greater return than displayed in the example before exercising the call becomes likely (at least for you).

No, not for me. For everyone. You made an investment. You sought a certain return. You did not earn that return. so what? Today is decision time: You take your $5 or you don’t. ‘Return’ no longer applies.

You are confused because you are looking at too many variables

You are concerned with break-even. You are worried about whether your strategy is working. You think about producing ‘a greater return.’ NONE of that matters at the time when the call owner decides what to do with the options: sell, exercise, discard. You either take the $5 or you don’t. It’s that simple. There is nothing else to consider. The fact that you have irrelevant items on your mind is the reason this is a problem.

I’m still left not knowing at what stock price / strike price combination calls are usually exercised. [MDW: Of course you know. When the stock is at least one penny in the money options are exercised.] I suppose as a buyer it would be when the stock price is greater than the strike price plus the premium. [MDW: NO] As a covered call seller it probably would be best to assume it would be when the stock price exceeds the strike price.[MDW: YES] Although this is not technically correct since a call’s price must be greater than zero to be sold, it’s probably good enough.

Calls are always exercised when they are in the money at expiration. Period.

There may be the occasional individual investor who correctly (for his/her situation) decides that exercising is too expensive because of commissions (and there were no bids when he/she tried to sell the call), but in general, all ITM options are exercised. That is all you or anyone needs to know.

Over the years, if (and only if) you can overcome your mental block, you may not be assigned a couple of times when the option is ITM by a penny or two. Just don’t expect it to happen.

I appreciate your efforts to help me with my question. I’m sure when my covered calls expire next week I will have an even better understanding that can only come from experience. Thanks again.

You are welcome. However, your entire conversation was from the point of view of the call owner. As the call seller you will learn zero about the mindset of the call owner. ZERO.

You must open your mind, throw out your misconceptions, and the truth will be right there in front of you. This is not difficult. This is the easy part. If you cannot understand this, there is no chance you can ever learn to use options effectively.

901

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More: When not to Exercise a Call Option

Yesterday's post collected a variety of comments and I thought an extended reply is in order.

One more reason why it's bad policy to exercise a call option when it first moves into the money.

1) It's a money-losing strategy with nothing to gain

Let's say that a trader wants to buy stock when it hits $60 per share or higher.  The reason is not important, but let's agree that this price represents a technical breakout and the trader wants to get long at that price.


Buy Stop

The correct procedure is to place a (market) buy stop order.  By taking this action, the trader's broker issues a market order to buy the designated number of shares the instant that the stock trades at $60 or higher.

We know two things about this trade:

  • The price will be $60 per share, or perhaps a couple of pennies higher
  • If the stock never trades as high as $60, then the trader loses nothing and never buys the stock

 

Buy Call

Compare the actions of an options trader who has not yet learned his lessons about when to exercsie a call option.  With the same expectations as the trader who uses the buy stop order, the options novice buys call options (with a 60 strike price) and pays $300 apiece.

What happens? 

If the stock never gets to $60 by the time the options expire, the trader is out $3 per share.  Not one penny of that money was wisely invested.  It was a total waste.

It the stock does get to $60 and the trader immediately exercises the call option and own the shares as planned.  However, the cost is $63 per share.  In other words, this trader deliberately spent $3 more per share than necessary.

How can this be a good move?  No one makes this trade – unless the trader does not understand the most elementary ideas about how options work.

But it's even worse.  Now that the call has been exercised, losses are no longer limited to $3 per share.  If this stock tumbles to $58, this trader is not only out the $3 per share paid for the calls, but also loses $2 per share on the stock price.

Everyone must understand options well enough to grasp this message:  There is nothing to be gained and there is much to be lost when a call option is exercised any earlier than necessary.  [More on this in a prior post.]

819

 


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When not to exercise a call option

I generally take the approach that there is no such thing as a dumb question.  If you don't understand something, there's a good chance that others will also be in a quandary over the identical question.  However, I am reconsidering.  The second question below – and I have seen it many times – is truly a dumb question.

 

Mark,

Thanks for revisiting this topic.

What if I want to buy and sell calls but don't want to sell my current shares. Is there anyway to avoid this?

If I am selling covered calls, and the stock hits the strike price, isn't it almost a given that the stock will be called away from me and sold at the strike price?

Mike

***

To Mike,

1) Yes, there is a way to avoid selling the stock. One simple method is to hold the long stock shares in a different account.
Then if you are assigned an exercise notice you will still own the shares in one account and be short shares in the other account. You can repurchase those short shares whenever you want to do so and remain long the original shares
2) Of all the questions that I receive – and I appreciate each and every one of them – this specifc questions bothers me more than any other.  I get it repeatedly and cannot understand how that is possible. 
Warning: Anyone who asks this question should not be trading options.  Not now, and possibly not ever.
The most basic concepts of using options involves some consideration of how options are priced and what they are worth.  No one in his or her right mind would ever – and I mean ever – exercise a call option just because the stock 'hits the strike price.'
There are so many reasons why this is true that it painful to attempt to list them. Here are two.
a) Your question assumes that writers of call options only sell options that are out of the money.  Let me assure you that many traders sell options that are already in the money – and that means the stock has hit the strike price – even before the option was sold.
I, for one, would never write an out of the money covered call, preferring to always take the more conservative path of writing in the money call options. let me assure you that I have never been assigned the day I sold the options, even though the stock has already 'hit the strike price.'
Virtual guarantee

b) If the stock hits the strike price, it's almost a 100% guarantee that your option will NOT be exercised under those circumstances.
Do you want proof? Look at any stock that is above the strike price of a given call option.
For example, yesterday AAPL closed at $309.52. 
Look at the open interest for Nov 300 calls.  Is it zero?  Did everyone who was long that option exercise it when AAPL passed $300 on the way up?
Look at AAPL Nov 290 calls. Is the open interest zero?  Did everyone exercise his/her long AAPL Nov 290 calls when the stock moved past that price?
Is that open interest anywhere near zero? Does it look as if everyone who was long that option exercised?
Now kook at the price of the Nov 300 call.  If the call owner exercises he owns AAPL at $300 per share when it's trading $9.52 higher. Exercise and your call becomes worth $952.
Do you see that the call closed trading yesterday near $19?  If you sell that call, you collect $1,900.  Would you prefer to have $952 or $1,900?
Isn't it price far above the option's intrinsic value? Don't you understand that if the option were exercised the owner would lose every penny of that time premium?
If you do not understand every word of the explanation above you have no business trading options. You have no idea how options work and have zero chance – outside of good luck – to earn any money.
Learn the basics. Then trade.
3) I ask a favor: Where did you get the idea that the option would be exercised under the conditions stated? Please write again and tell me who is teaching people that this absurdity is within the realm of possibility.
816


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Exercise and Assignment. Not to worry

The exercise/assignment process is straightforward, easy to understand, and is experienced by almost every option trader at one time or another. 

An option is a contract in which the writer (seller) promises that any buyer has the right  to buy or sell the underlying asset at the strike price on or before a specific date.

Electing to buy or sell the underlying (per the contract) is referred to as 'exercising.'  Being notified that the exercise has been assigned to your account is referred to as an 'assignment.'

Unfortunately, many new traders become overly worried about the process because they  don't bother to pay attention to the rules regarding how the process works. Why would anyone trade an option without being aware that it's possible to be assigned early?  When we drive a car, we are supposed to learn the rules of the road.  Traders who don't take the time to understand what they are trading are flying blind.

I've discussed this topic many times (here's the first), and you can search (below) for Exercise and assignment to read some of the posts.


Free put, free call

Why beginner's fear being assigned an exercise notice is beyond my comprehension.   When anyone sells an option, he/she is accepting an obligation to be assigned.  So why is it it so unsettling to be assigned one of those exercise notices prior to expiration?

Being assigned an exercise notice turns a short call option into short stock.  So what?  That exercise is equivalent to giving the option seller a free put [same strike and same expiration as the option being assigned].

Being assigned an exercise notice on a put option does cost a bit of cash (in carrying costs), but it is equivalent to being given a free call.

It's unlikely that these free options will be worth anything, but every once in awhile lightning strikes and I love  being handed those free puts and calls.  Unless it results in a margin call, being assigned early is not a problem.  If it does result in a margin call, you are probably trading too many contracts for the size of your account.

 

European and American style options

European style options cannot be exercised prior to expiration.  If you absolutely cannot tolerate being assigned early, it may pay to trade European style options.  However, there are far more important items that differ between American and European style options that it's crucial to understand these differences before attempting to trade them.  this is not an idle warning.

To read more about these differences, search (below) for American vs. European options

815

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Early Exercise: Call Options

I have not posted about the concept of early exercise for some time.
It's amazing to me how this idea gets out of the starting gate and simply will not go away.

Mark,

How would a trader like you decide to do early exercise? 

Say you bought calls when they were trading in the 1.0 -> 2.5 range, now underlying has risen so that calls trade bid-ask at 4.0 / 4.8 and there is strong possibility of it going higher. Also assume in another case that they trade in the 6.0 to 7.0 range.

What would make you wait for early exercise till Wednesday morning, Thursday morning, Friday morning of expiry week as a trader?

Assume you have cash to buy all contracts. The time value is negligible, and theta is eroding it fast.

Would you change your mind if the risk-free interest rate was say 8% and not 0-1% as currently?  Is that rate a huge factor for 2-4 days anyway?

I read some books where a bunch of math experts say that except for a dividend-paying underlying, early exercise is impossible.

Personally, if I were the call buyer and I had bazillion money, I would not sell the calls as the bid/ask spread widens and the market makers play games. I would choose early exercise sometime on late Wednesday or anytime Thursday to remove option spread slippage, so I buy underlying at the strike price and immediately sell it to lock in profit, because underlying spread is narrower than the option spread.

Very interested in your reply.

Thanks

Amit,

***

This is a very easy question.

1) I WOULD NEVER, exercise a call option prior to expiration – UNLESS it is to capture a dividend.

Before I go further, there are three valid reasons why someone may want to exercise a call option early.  My guess is that >99% of all option traders will never encounter these situations. 

If there is a dividend, sometimes a call owner must exercise the option or it is throwing money into the trash.  The call must be ITM, the delta must be 100 and the option should not be trading over parity. 

A professional trader (market maker) may prefer to sell stock short to hedge some trades.  If he/she does not own long stock, then when expiration is near,  deep ITM calls can be exercised and the long stock immediately sold. That is not as good as selling short stock, but must suffice when there are no better alternatives.

When expiration is near and the call option is deep ITM, sometimes the option bid is below parity.  In that situation – and it is not that common because most traders do not hold onto options that move deep into the money – then it's often better to exercise and immediately sell stock than it is to sell the call. 

Selling the call is preferable because it saves commission dollars.  But if the bid is too low, then the trader may have to exercise.

These situations exist, and I mention them for the purist.  However, my contention remains that if you are a retail investor, you can easily go your entire lifetime and never exercise a call option – or have any reason to do so.


A smart retail trader NEVER exercises a call option.  What can be gained?  Think about it.  Why would anyone prefer to own stock and suddenly have downside risk.

If you are assigned an exercise notice on a call option prior to expiration, consider it to be a gift (unless you cannot meet the margin call).

2) If I no longer want to own the option, I sell it.  You seem to arbitrarily hold options until Wed/Thur of expiration week.  That is terribly foolish.  The ideal time to sell an option is when YOU no longer want to own it – not on an arbitrary calendar date.

3) The price paid for the option is 100% irrelevant.  I don't know why so many people get hung up on this.  Assume you own a call option and the price is $6.  Assume you no longer believe the stock is moving higher.  Does the price paid for that option change the decision to sell?  Would you sell if the cost were $2 but hold if you paid $7?  If 'yes,' then you don't understand trading. 

When you no longer want to own a position then don't own it.  Do not hold just because it would result in a loss if you were to sell.  You already lost the money, and holding invites a larger loss.

Bottom line: You either want to exercise your option, or you don't.  You either want to sell your option, or you don't.  The price you paid is ancient history and 100% immaterial.

4) If the time value is negligible, then there is no theta to be 'eroding fast.'  Theta is the erosion of time value.

5) I would never change my mind.  Period.  Exercising a call option is stupid (exceptions noted above).  Just take that as gospel.  It is stupid.  Just sell it when you don't want to own it.  Interest rates do not matter over a two-day period.  But why own stock for two days?  Don't exercise.

6) If the option bid is less than parity (i.e. if you cannot get at least a fair price for the option), then it is possible to exercise and IMMEDIATELY sell stock.  But this involves extra commissions and is probably still a bad idea.

It is NOT the bid/ask spread that matters.  If the stock is 60 bid, you can sell stock at 60.  If you own the 50-call and the market is 10 bid 14 asked, what difference does that make to you if the market is wide.  If you can sell at 10, that is easier and less expensive than selling stock.

If however, the market is 9.90 to 10.10, that's a nice tight market, but does you no good.  You want to sell the call at $10.  So yes, in this example, you may exercise and immediately sell stock.

Exercising calls to own the shares is a trade made by someone who should not be trading options.  One more point – if you were to make the mistake of exercising early, why would you do it in the morning?  Wait until the close of trading.  It is possible that the stock will decline 20 points that day and you would be left holding the bag.  Exercise instructions are irrevocable.

Amit,

I have a problem when responding to question such as these.  If you have been trading for a two years, then none of this should be unknown.  On the other hand, if you have been trading two months, then it is reasonable for you to have not yet considered these ideas. 

When replying, I do not know to whom I am addressing the answers.  It can be someone who just doesn't get it, or it can be to a very eager to learn beginner. 

743

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