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.]

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5 Responses to More: When not to Exercise a Call Option

  1. Larry 10/23/2010 at 8:34 AM #

    I have several questions:
    1.) Where can I get a list of the 2500 companies that are approved to have options listed for trading?
    2.) I know that one can buy calls in an IRA. Can one buy calls and puts in a ROTH IRA? Levels 1 and 2? I assume that would have to be a self-directed Roth IRA. Is that doable?
    3.) In real estate, one can option a property, like a stock, and then write a contract on the property to a new buyer at a higher price in a way that the buyer takes title to the property without the optionee having to take title first before he passes title to the final buyer. The deed is signed by the optionor, the original seller, in favor of the final buyer thus saving the optionee the costs of getting a loan and paying closing costs twice. And the optionee gets the difference between the original sales price and the final one.
    With that in mind, I have been thinking about options. Suppose I option ABC stock, strike price of $20 is at-the-money price of $20 for a $2 premium. The underlying stock raises to $26. I want to realize the gain of $4 ($6 minus the $2 premium.) You say I can sell my option without having to take title to the stock, realizing the gain.
    Scenario 1: So the stock is now worth $26. If I buy it, and then resell it for $26, notwithstanding volatility issues, I realize my net gain of $4, less commissions.
    Scenario 2: So the underlying stock is now worth $26 and I still own the option. If I sell out of the option, without first buying the stock and then selling it, is my realized gain still $4? Is the new buyer of the option paying me a premium of $6 to buy the option, such that my net profit position is still $4? I am unclear how the dollars are calculated when someone buys out my position of the option I own. It appears that the value of the option goes up equal to the rise in the stock, assuming it is going above the value of the stock at the purchase of the option, but still, that is not clear. Which would imply that if the stock goes up $6, so does the price/value of the option (time left on the option not withstanding) Same question with puts.

  2. Mark Wolfinger 10/23/2010 at 9:19 AM #

    Larry,
    1) You can get a list of all options listed for trading from the OCC.
    http://www.optionsclearing.com
    or ask via email: options@theocc.com
    2) Yes. You are permitted to use a ROTH in the same way you use a regular IRA.
    WARNING: The rules allow you to do as you ask. However, each broker makes the final determination of what they allow. Many brokers will NOT allow IRA options trading – other than covered calls. Thus, ask your broker what they allow.
    WARNING TWO: Buying puts and calls is such a high risk, low probability chance of making any money. Are you certain this is how you want to ‘invest’ your retirement funds? This is a very bad idea for retirement money, in my opinion.
    More later. Short on time right now.
    Thanks for the questions.

  3. Mark Wolfinger 10/23/2010 at 9:43 PM #

    Larry…continued
    3) Terminology: You do not ‘option a stock.’ Instead, you sell a call option with a $20 strike price.
    Scenario ONE. Yes. Plus you pay a fee to your broker to exercsie the option and another to sell the stock.
    Scenario TWO: Your realized gain is at least $4. That option is worth $6 and you can sell it for that amount – or higher.
    As an extra bonus, you pay only one commission: to sell the option.
    Don’t be ‘unclear’ about calculating ‘the dollars’ when you sell an option you own. It is EXACTLY the same as when you buy ANYTHING and then sell it. Options are no different. If the sale price is higher than the purchase price, you earned a profit.
    The value of the option did not go up ‘equal to the rise in the stock.’ The stock moved $6 from $20 to $26. The option moved higher by only $4, from $2 to $6.
    Puts work the same as calls. There is no difference, except for direction of the price change of the stock.
    I suggest reading on the topic: How options are valued.
    Larry: If this is not clear, ask again. This is a very simple concept. I’ll help you get to the point where it does not confuse you.

  4. Larry 10/24/2010 at 8:14 AM #

    Thanks for taking the time to answer my questions. Regarding puts, I need a little more clarification. Here is what I understand so far: Underlying stock price is $20. For a premium of $2, I buy a put at-the-money price of $20 with the strike price of $20. The stock goes down to $15. I close the put and realize a net gain of $3 ($5 minus $2 premium). Right?
    So here is what I don’t understand: I expect the seller of the put is hoping that the stock stays the same or goes up so that I do not exercise the put and sell or buy the stock. But if is goes down so that I want to exercise my rights under the put, it is not clear what happens. So, when I exercise the put, the seller of the put parts with his stock, which he committed to selling at $20, but now is worth $15. Where does the $5 come from to fund my realization of gain? Out of pocket from the seller? He has the $2 of the premium, but it seems he has to make up the other $3 with cash.
    RE: Selling covered calls: If the worst happens to the seller, namely that the price goes up and the call buyer exercises his option, it is not so bad: the seller did get a what once was fair price for the stock plus the premium. He might have missed out on some upside gain, but it was never really his, so the loss of said upside gain is not so painful.
    RE: Selling covered puts, I assume they are covered, when the buyer of the put exercises the option, A.) the seller gives up the stock at a lower price and B.) has to also part with the difference between the strike price and the current price, in this case $5 ($3 cash and the $2 premium). It seems a lot more painful to experience an actual out of pocket cash loss than missing out on a potential gain. Am I close to understanding this?

  5. Mark Wolfinger 10/24/2010 at 10:47 AM #

    Larry,
    I have much to say in an effort to offer good guidance.
    Complete post Tuesday, 10/26/2010
    Regards