Q & A. The exercise decision. It’s not complicated. Part II

Questions from Scott. Part II. Part I.

3. If a strike price is in-the-money at the time of option
purchase, is it possible to exercise the option at any time? For instance, SRZ
last traded for $4.28 and has a November strike of NOV 2.5. It has an ask of
$2.15 for a break-even of $4.65.

Any option on an individual stock can be exercised at any time. No exceptions. 

The language of options: A 'strike price' is never 'in the money.'  Only the option is in- at- or out-of the money.  

Let's look at your example.  Why would you want to exercise that
option?  Never exercise an option that has time premium in it's price. 
Do you know what time premium is?  It's the money you immediately lose
when exercising an option.

If
you pay $215 and then exercise, your total cost is $4.65.  When you
immediately sell the stock, collecting $4.28, you have a loss – plus
you paid commissions for the privilege of taking that loss.  Do not do
this.  If you wait until the stock is $4.65, you still have no profit. 

Your profit potential comes from selling the option at price higher than you paid – not from exercising the call option.

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4. In theory, I could buy a put option
for $1 a share on a stock trading at $24 with a strike price of $24. If the
stock dropped to $19, I could then exercise the put option with the right to
sell it at $24 per share for a $5 per share profit, minus premiums. Is this
correct? Who would buy the stock at $24 a share?

An option is a contract.  There is a legal requirement that the parties to a contract honor their obligations.

When
someone sells an option, that person is paid a cash premium.  Do you
think the option buyer pays that cash premium just for the fun of
paying?  Not a chance.

The
seller
accepts certain obligations in return for collecting the cash premium
and in your example, is obligated to buy the shares at $24 if
and when that person is assigned an exercise notice.  The seller can't
say 'I changed my mind.'  Nor can he say 'I'm not buying.  Try to force
me.'  There's none of that childish stuff.  This is business.  It's a
legal contract.

When
assigned an exercise notice on a put option, the option seller's broker places the
stock into that person's account and withdraws $2,400 per option to pay
for the stock.  It's done overnight and the option seller is notified
the next morning.  It's a done deal.  It cannot be reversed. 

But once again, just sell your option, collecting $5 for the same $400 profit.  Why exercise?

It's
shocking to me that you are considering using real money when you lack
an understanding of how options work.  Please, do yourself a big
favor.  Get a copy of The Rookie's Guide to Options. Read it.  All the details are there to help you understand what you are doing when trading options.

***

5. What is the
difference between a put and a naked/uncovered put? Is it true that in both
options, you do not own the underlying stock?


The owner of an option is never considered to be 'uncovered.'  That term is used only for options sellers.

A 'naked' or uncovered option means the option seller does not have an offsetting position in the shares. 

Thus, a naked put is a put sold by an investor who is not SHORT 100 shares of stock for each option sold.

When you sell a put option it does not
matter whether you are LONG the stock.  If you are not SHORT stock, then
you are uncovered.

A naked call is a call option sold by an investor who is not LONG 100 shares of the underlying stock for each call sold.

When
assigned an exercise notice, if the investor has the shares in his/her
account to offset the exercise, then the option was covered.  If there
are no shares, or not enough shares, then the option is naked or
uncovered.


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6. If you sell a put and
the stock drops and is assigned to you, do you have to maintain sufficient cash
to cover the stock purchase at or below the strike price until the option is
exercised by the buyer or expires?


Once the option is assigned to you, you OWN the stock.  You already paid for it (past tense) as soon as you were assigned that exercise notice.  You do not need any additional
cash, but you must have enough cash to have paid for the stock. Or, as
an alternative, you can borrow the cash from your broker if you have
enough assets.

***

Thanks for all of your help!

Scott

Scott. 
You raised important points.  But points that everyone must understand
before trading options.  If you appreciate the replies, please answer
my questions. The information will help me better understand the
misinformation being generated.

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