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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13 Responses to Early Exercise: Call Options

  1. amit 07/19/2010 at 11:31 AM #

    Whoa Mark,
    Be merciful!
    Sometimes I don’t get it because expiration is not told clearly in the literature. I have been doing call spreads for 2 months only. I am a eager beginner. I don’t buy options as I do not believe in wasting assets having understood that quite late, buying calls is for insurance only and because it is prudent and mandated.
    Please let me think and I will post later today.
    Thanks

  2. Mark Wolfinger 07/19/2010 at 11:39 AM #

    Amit,
    The ‘literature’ often assumes too much and I agree, is not clear. That’s the primary reason for writing The Rookie’s Guide to Options. Everyone deserves a clear explanation of the rules of the game.
    My frustration with ‘early exercise’ is not directed at you. I get many questions on this topic and I just don’t know why anyone would think early exercise is a viable idea. It has nothing to do with you.
    We all define an option as giving its owner the right to exercise. I always point out that it may be a right, but that is technical. There is no reason to exercise (exceptions mentioned above).
    Take your time. I’m here to try to help
    Regards

  3. John 07/19/2010 at 2:17 PM #

    Mark,
    What values of gamma do you consider as high?
    Cheers

  4. Mark Wolfinger 07/19/2010 at 2:30 PM #

    John,
    Regarding a position, it’s high when I am going to lose too much money if the stock moves an additional X points.
    Reminder: Gamma is the rate at which the option delta changes when the stock moves one point. When delta moves from 30 to 32, that’s not a lot of gamma. When delta changes from 30 to 50, it’s very high.
    ‘High” does not necessarily have a ‘number’ associated with it. Let’s look at it this way. You have a (premium selling) trade and it goes against you. You adjust delta back towards zero.
    Assume you are going to adjust again when the stock moves another X% or Y points higher. You will again be short delta and have lost some money between adjustments.
    If the number of delta you are short is too high and if the loss is larger than you want to accept between adjustments, then gamma is HIGH. It means delta changed by too much.
    Choices: Adjust sooner or reduce negative gamma.
    Thus, ‘high’ is a relative term. I’ should have more to say on this topic. Let me ponder.

  5. Don 07/19/2010 at 6:38 PM #

    Hi Mark, I hope that you do detail your thoughts on Gamma becuase I am interested in this discussion too. When I am lookin at the brokerage account I have the same types of questions- what is considered high (risky) Gamma and what is low (safe) amounts of negative Gamma. Knowing what you say about Gamma is there a method of factoring in the effect it has so that it is used to advantage when trading or adjusting?
    Thanks, Don

  6. Mr. M 07/19/2010 at 7:13 PM #

    In reference to call options you might want to note that if it is even a cent over the strike price on the last day of the option period, your broker will exercise the option automatically unless you specifically contact them each and every time not to exercise the option. I found out the hard way as it was my plan to let some virturally worthless options just expire without exercising the call. The following Monday, I found that I now owned those stocks.
    Live and learn. Any comment?
    Mr. M

  7. Mark Wolfinger 07/19/2010 at 8:58 PM #

    Mr M,
    It angers me that it is the responsibility of the option owner to notify the broker ‘DO NO EXERCISE.’
    It’s an outrage.
    The contract stipulates that the option owner has he right but not the obligation to exercise, yet at expiry those rights are turned into obligations.
    Class action lawsuit is in order.
    I wrote about this at length in Jul 2010 issue of Expiring Monthly.
    Regards

  8. Mark Wolfinger 07/19/2010 at 10:09 PM #

    Don,
    Sure, there’s a way to factor in any Greek. Most people like to adjust to delta neutral, but any trader can adjust to gamma or vega neutral as well. Even theta neutral.
    However, premium sellers must remain short gamma to earn positive theta. The idea is not to have so much neg gamma so that you are not in danger of losing ‘too much too quickly.’
    Because that phrase in quotes is obviously based on individual risk tolerance, just keep gamma under control. It’s one reason why I prefer to adjust by buying something with positive gamma, not stock and certainly not by selling options.
    However, to each his/her own.

  9. amit 07/20/2010 at 12:44 PM #

    Hi Mark,
    Sorry for not replying earlier.
    1) You replied to my question in here
    “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. ”
    I didn’t like the way it was going so I took a loss, my thinking at that time was “the market is poised to go higher”. But I should have just gotten out much much earlier. The loss was 8% of my total, so not unrecoverable. But lesson learned for another day.
    2) Lesson digested, and will pull the trigger much earlier. If profit is a huge percentage of the total, then I will get out.
    3) But my point here is that if your trade goes bad, then try to recover as much of that bad trade as you can. But I won’t next time, as long as its close to breakeven and its coming to expiration week, I will liquidate.
    Thanks

  10. amit 07/20/2010 at 12:46 PM #

    Mr.M and Mark,
    I didn’t know this either. This ain’t in the books or articles either. It might be in some forum or other, but not have wide distribution. Some things you can’t learn in virtual trading.
    Thanks

  11. Mark Wolfinger 07/20/2010 at 1:53 PM #

    Amit,
    It’s in the fine print somewhere. It’s definitely in The Rookie’s Guide to Options.
    The major problem is that people, anxious to play the game (any game) often get involved and never bother to read the rules.
    For example: Does anyone read the fine print that comes with a credit card application? How about medicine? This is just one important detail that people should know, but don’t.
    I’m glad you are now aware.

  12. Mark Wolfinger 07/20/2010 at 1:59 PM #

    Amit,
    This is not an assignment. Respond any time you want to continue the conversation.
    1) Again, in my opinion, whether a given trade is profitable is not important. When you decide it’s best to exit – that’s the best time to exit.
    2)Again, that is not how I would trade. But it’s certainly a viable plan. If it works for you, then by all means, adopt it. Keep in mind that ‘huge percentage’ is a relative term.
    3)Once again, my recommendation is to liquidate when you believe it’s the right time to liquidate.
    Regards

  13. amit 07/20/2010 at 2:08 PM #

    I am glad you understand! I try to stick to my word.