Q & A. When to Exercise. Is it Really a Diffficult Concept?

I receive more questions of the topic of when the owner of a call option may want to exercise that option than on any other topic.  This is a very basic part of options trading, and it's mandatory to recognize when and why an option owner would want exercise an option. 

Is this really such a difficult concept to grasp?


Mark,

I'm a beginner. If I were writing an in-the-money covered call, would
the strike price need to be reached before the buyer would call away
the stock shares?


Thanks for your help.

Alex S.

***

Alex,

When you write an in the money covered call, the strike price has already been 'reached.'  The stock is higher than the strike price. That's why it's called an in the money call option

That fact, all by itself, is enough to tell you that seeing the stock 'reach' the strike price is an insufficient reason for the call owner to exercise the option and 'call away' the shares.  How do you know that?  Because investors are willing to pay a price higher than the intrinsic value of the call option.  No one in his/her right mind would pay a premium above intrinsic value and then throw away that premium by immediately [the buyer may want to exercise weeks or months later, but NOT NOW] exercising.  Here's an example:

You own shares of YZX which is currently trading at $52 per share.  You sell some YZX 50 call options (expiration date is immaterial) and collect $350 for each.

NOTE:
These options are 2 points in the money.  That means the stock is $2
higher than the strike price, and thus, the intrinsic value
of the option is $2 per share. The time premium  [total premium minus intrinsic value]
is $1.50 per share, or $150 per call.

Let's look at this from the perspective of the call buyer.  He/she had these choices:

a) Buy stock, paying $52 per share.

b) Buy YZX call options with a strike price of 50, paying $3.50 per share.  Hold the options until it's time to do something with them.

c) Buy YZX call options with a strike price of 50, paying $3.50 per share.  Immediately exercise the option to take delivery of the shares.

Your question suggests there is a possibility that the call owner may want to select (c).  If he/she exercises, it costs $50 per share to own stock.  Add to that the $3.50 per share paid for the option, and the cost is $53.50 per share.

Why would anyone want to pay $53.50 (plus extra commissions) to buy stock that is available at $52?  Answer:  No one would do that.  It's possible, but unlikely, that it may be appropriate to exercise the calls at a later time.  But that is a totally separate discussion and unrelated to your question.

You must understand why an investor will NOT exercise.  Do not consider making a single option trade until you know for sure that the buyer of a call option is not going to exercise when the stock reaches the strike price.

Therefore, no one is going to exercise the call options (the ones you sold), just because the stock reaches the strike price.  You will not receive an exercise notice and you will not be obligated to sell your shares [of course, if the call owner blunders, it is possible to be assigned that exercise notice.  Just don't expect it to happen in your lifetime.]  That's true no matter how high the stock moves.  Any call owner who no longer wants to own those options gets rid of the position by selling the options – not by exercising.

If the option owner were to exercise the option when the stock hits the strike price, that would be a bad blunder.  You never exercise an option when it has time premium remaining (that means any time it is trading at a price higher than the intrinsic value of the option). There are other, very important reasons for not exercising, but you must understand this one before thinking about other reasons: you want to comprehend the basics before moving on.

***

If you meant to ask about an out of the money covered call, the same principle holds true.  The call owner will nave NO reason to exercise any earlier than necessary (expiration).

The following is a very minor oversimplification and there are a couple of exceptions, but in general you can take the following statement as gospel:

IT IS ALMOST ALWAYS WRONG FOR ANYONE TO EXERCISE A CALL OPTION PRIOR TO EXPIRATION.

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