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.



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

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.

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.

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

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

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

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.

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

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.

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.

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. 

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?

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

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"

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:

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.

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.


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

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?]

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


4 Responses to Q & A. The exercise decision. It’s not complicated. Part I

  1. Rob 10/22/2009 at 8:38 AM #

    Can any reader help me discover the source of the suggestion that option owners should exercise options to take their profits?
    Hi Mark,
    I am a subscriber of an options service offered by the Motley Fool. (I am slowly coming to some conclusions about that service, but that’s off topic for now.) There are far, far too many posts written by members who are eager to “get started” but clearly lack any foundation or basic understanding about using options.
    To your question, and based on my observations while subscribed to the service, I think there are two reasons why rookies are under the impression that options should be exercised.
    1. The terminology is confusing for people who are trying to get started. Letting an option “expire worthless” sounds like a bad decision. “Exercising” your right to do something sounds like a good decision. It’s a basic misunderstanding due to not taking the time to read and study.
    2. I am completely amazed at the number of basic questions being asked that could have been answered by taking a few minutes to read the materials that are available to members of the service. I’m left to ask myself “Does anybody read anything anymore?”. The only conclusion I can draw is that many people are eager to get started, but don’t want to study the topic before they do. In a sense, they’re in a hurry to lose money!
    I’ll be curious to read about other ideas people might have on this topic!
    Regards, Rob

  2. Mark Wolfinger 10/22/2009 at 8:46 AM #

    Of course they are really in a hurry to make money, but fail to understad that they are ill-prepared.

  3. Marty 10/22/2009 at 9:33 AM #

    I agree with Rob’s points. I think people also don’t have a lot of natural experience with selling an active contract in the real world, so the concept takes a while to sink in. Usually in life, it’s “use it or lose it”…for instance a gym membership is an option to “exercise” (sorry, that’s an awful pun) and there is no market to sell that membership for a profit or loss. With that said, you’re right of course that a little more research would clear up the issue for those people.
    I guess you could think of this blog as being part of the research Scott is doing. He may be jumping the gun using any real money at this point, but it’s fortunate that he asked his question first.

  4. Mark Wolfinger 10/22/2009 at 9:41 AM #

    I understand what you are sayaing, but for clarification want to mention: only option buyers have the right to exercsise
    Opion sellers have no rights.