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Exercising at Expiration: A real world example

Hi Mark,

Let me first say that I have been reading your blog for a couple months and I found it very educational. I really appreciate what you are doing.

On your latest post about options expiration, you mentioned that you don't like exercising. In fact that is what I did this past Friday and I'd like your insight on that.

I bought 2 (Discover Financial Services) DFS 15/17.5 April 2010 call spreads back in December when they cost me $0.88 and DFS was around $15. DFS has since dropped below $13 but went up a lot after it bottomed. During the past two weeks I finally saw a way out with profit when DFS was getting close to $16.

On Thursday it gapped open to more than $16.50 and I thought I could close the spreads at $1.40.  I entered the order but it didn't get filled. I thought I'd wait until Friday and enter another order. Then on Friday the stock slides further and I can't even make it even.

I exercised and planned to sell ITM expiring in a couple months (Ask prices of the May and Jul $15 calls are $0.90 and $1.30) to get out with a profit. Of course I know that DFS may drop again but I am willing to hold the stock and write calls. Essentially I'm exercising so I can still hold the position when my Apr $15 calls expire.

What are your thoughts?

Thanks a lot.

F

***

Interesting scenario for you.

1) You have a plan.  Your plan is to hold the stock and write covered calls.  That's fine by itself.  The crucial part of this exercise is that you planned ahead and know what you want to do.

But I do have a question, and that comes later.

2) My problem with exercising, as a general practice, is that someone who bought an option for a specific reason forgets the original reason and suddenly owns stock.  Along with that stock comes a great deal more risk than the original trade.  That's just a bad idea, and cannot work over the long term.

When you buy an option (or spread), if your original premise doesn't become reality, accept that fact and exit the trade.

3) Here's the big question that makes me doubt that you did a smart thing.  And remember this is my opinion, it is not necessary for you to agree.

Quote 1: "Then on Friday the stock slides further
and I can't even make it even."

Quote 2: "I exercised and planned to sell ITM…to get out with a profit."

Quote 3: "During the past two weeks I finally saw a way out with profit"

My question:  Did you exercise those calls just because you refused to exit this trade with a loss?

Planning to write covered calls is a very reasonable idea.

Planning to write covered calls just because you refuse to accept that this position lost money is beyond foolish.  Because you mentioned it three times, I believe you don't really want to write covered calls.  Instead you are obsessed with getting back to even or earning a profit.

As an option trader, you must know that you will have winning trades and losing trades.  That's part of the game.  If you accept additional risk (and owning a $15 stock is substantial extra risk when compared with owning a call option), just to avoid a loss, you are going to incur some much larger than hoped for losses.  Yes, you will also turn some losses into profits.

I have my trade philosophy and you certainly should have yours.  According to mine, these are the points I believe that should matter to you:

  • Is it your thought that writing covered calls is the best play in DFS?
  • Is there no play, with less risk, that appeals to you more?
  • If you do want to write covered calls, is it a good idea to hold the stock naked long over the weekend?
  • Are you writing covered calls ONLY because you refuse to take a loss?

You had a choice.  Exit the calls and open a new position Monday (yesterday); hold via exercise; or buy the Apr 17.5 calls and sell the May or Jun call last Friday (if you had the margin available to make that trade).

My major comment is that the exercise is okay – but not if you did primarily to avoid taking a loss.

669


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