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.

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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


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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.

164

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

One Response to Option Education; Please Don’t Trade Without It

  1. Mike S. 11/15/2008 at 12:07 PM #

    Great, thank you for clearing this up! Excellent analysis.