Tag Archives | call option

Selling a Call Option: What do you Get?

Once again a reader (thank you Debi) asks about something that goes beyond the typical education received by option beginners.


Mark,

1) Let's say I bought a call and the underlying stock
moved down, dropping below the strike price. I could salvage
what is left of the contract by selling the entire position. How much
could I possibly get from trying to close the position early?

Is it
better to just wait until the end and hope for a miracle?

2) If I buy a call and the underlying stock moves higher, I sell the
option and make a profit: the difference between the price I paid and its current price.

I am confused. Do I get both intrinsic
value gain and the difference between what I sold it for and the
premium. How do you know what you sell it for?

Debi

***


1) It is seldom 'better' to hope for a miracle.  When all you can salvage
is $0.05 or $0.10, then you may as well go for the miracle.  Otherwise, selling the call option at a loss is a smart move.  It will not be the winning move 100% of the time, but on average you will be better off selling.

The questions are: when to sell and how much can you get.


When to sell



You bought the option for a reason.  You anticipated the stock would make a favorable move.  It doesn't matter what the reason was: if you change your mind and no longer believe the stock is going to make the move, or you believe the move has already occurred, sell the options.  There is no reason to hold them – and watch time decay kill their value – when your reason for buying the options is no longer valid. 

Repeat: You buy an option for a reason.  Do not hold that option when that reason no longer applies.

You must anticipate many losing trades when you buy options.


How much you can get depends on three factors:

a) Time.  If there is not much time remaining (when you change your mind and decide to sell), the premium is less (yes, that's obvious).

b) Stock price.  I'm sure you understand that the father below the
strike price, the less you receive. The option delta offers a
good estimate of how much lower the option price will move – if the
stock declines by one more point – today.

c) Implied volatility.  Some options (volatile
stocks) trade with a higher premium than options of tamer stocks.  If
you paid a relatively high price because this is a volatile stock, you can recover more cash than when the option is for a non-volatile
stock.

Bottom line: No easy answer, but selling when you change your mind is the correct approach.  There is no reason to wait.

2) The simple answer is you 'get' the current price.  You 'paid' what you paid.  The difference is your profit (or loss).

First, Let's be certain there is no confusion over terminology.  The 'premium' of an option is the price of the option.

Some traders mistakenly use the term 'premium' to represent the 'time premium' in an option.  The 'time premium' is the total premium (option price) minus the option's intrinsic value.

Example:

A stock is trading at $53 and the Jul 50 call is $4.20

Intrinsic value = $3.00 [$53 (stock) – $50 (strike)]

Time premium = $1.20  [$4.20 (premium) – $3.00 (intrinsic)]

Premium = $4.20  [option price]

When you bought the option, you paid a specific price (premium). 
When you look at the current bid/ask quotes for the option, you know
you can sell at the bid price – and perhaps a little above that
price.

That's the best way to know what you can get when selling the option.  I assume by 'what you can get' you are referring to the price.  One word of caution:  It is best not to enter a 'market order.'  You will do better to use a limit order – just be certain it's a realistic price.  When selling, that means it should be nearer the bid price than the ask price.

If you just want to estimate the price you can get without seeing the current
market quote, then, you 'get' the current intrinsic value of the option
PLUS an unspecified amount of time premium. 


If expiration is nigh, expect that time premium to be less than if there were more time remaining.



If the option has a high intrinsic value (the option is far in the money), then the time premium is also reduced.



Regarding the confusion: 

In theory:


a) You do get the increase in the intrinsic value of the option

b) But you lose some time premium for two reasons

Time passed since you bought the option, and you pay for that time decay (theta).

The intrinsic value has increased.  Options with higher intrinsic value lose time value. 

It's difficult to explain in a sentence, but that residual time value is based on the likelihood that the option will move out of the money (if the stock tumbles).  The higher the intrinsic value, the less chance of that happening.  Thus, time value is reduced.



Bottom line: NO.  You do not get both items listed in your question. 
You get (i.e., the cash you can take to the bank) the current premium (price). 

Debi, you get ONLY the difference between your purchase price and sale price (less commission).  That is true for all types of trading.  Options are no different.  You can break up the option price (premium) into its component parts, but that is unnecessary. 

When you see the price that you can receive when selling the option (the bid) calculate the intrinsic value and the remainder is the time premium.  Based on your question, I believe what you want to know is: How can you determine the profit (or loss).  And that's the difference between price paid and price sold (then subtract commissions).


I hope you are familiar with the terms used.  If you are still uncertain, please request a clarification.

Regards,

749

Lessons of a Lifetime, an electronic book (.pdf file).  My 33 years as an options trader.



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Early Exercise: Call Options

I have not posted about the concept of early exercise for some time.
It's amazing to me how this idea gets out of the starting gate and simply will not go away.

Mark,

How would a trader like you decide to do early exercise? 

Say you bought calls when they were trading in the 1.0 -> 2.5 range, now underlying has risen so that calls trade bid-ask at 4.0 / 4.8 and there is strong possibility of it going higher. Also assume in another case that they trade in the 6.0 to 7.0 range.

What would make you wait for early exercise till Wednesday morning, Thursday morning, Friday morning of expiry week as a trader?

Assume you have cash to buy all contracts. The time value is negligible, and theta is eroding it fast.

Would you change your mind if the risk-free interest rate was say 8% and not 0-1% as currently?  Is that rate a huge factor for 2-4 days anyway?

I read some books where a bunch of math experts say that except for a dividend-paying underlying, early exercise is impossible.

Personally, if I were the call buyer and I had bazillion money, I would not sell the calls as the bid/ask spread widens and the market makers play games. I would choose early exercise sometime on late Wednesday or anytime Thursday to remove option spread slippage, so I buy underlying at the strike price and immediately sell it to lock in profit, because underlying spread is narrower than the option spread.

Very interested in your reply.

Thanks

Amit,

***

This is a very easy question.

1) I WOULD NEVER, exercise a call option prior to expiration – UNLESS it is to capture a dividend.

Before I go further, there are three valid reasons why someone may want to exercise a call option early.  My guess is that >99% of all option traders will never encounter these situations. 

If there is a dividend, sometimes a call owner must exercise the option or it is throwing money into the trash.  The call must be ITM, the delta must be 100 and the option should not be trading over parity. 

A professional trader (market maker) may prefer to sell stock short to hedge some trades.  If he/she does not own long stock, then when expiration is near,  deep ITM calls can be exercised and the long stock immediately sold. That is not as good as selling short stock, but must suffice when there are no better alternatives.

When expiration is near and the call option is deep ITM, sometimes the option bid is below parity.  In that situation – and it is not that common because most traders do not hold onto options that move deep into the money – then it's often better to exercise and immediately sell stock than it is to sell the call. 

Selling the call is preferable because it saves commission dollars.  But if the bid is too low, then the trader may have to exercise.

These situations exist, and I mention them for the purist.  However, my contention remains that if you are a retail investor, you can easily go your entire lifetime and never exercise a call option – or have any reason to do so.


A smart retail trader NEVER exercises a call option.  What can be gained?  Think about it.  Why would anyone prefer to own stock and suddenly have downside risk.

If you are assigned an exercise notice on a call option prior to expiration, consider it to be a gift (unless you cannot meet the margin call).

2) If I no longer want to own the option, I sell it.  You seem to arbitrarily hold options until Wed/Thur of expiration week.  That is terribly foolish.  The ideal time to sell an option is when YOU no longer want to own it – not on an arbitrary calendar date.

3) The price paid for the option is 100% irrelevant.  I don't know why so many people get hung up on this.  Assume you own a call option and the price is $6.  Assume you no longer believe the stock is moving higher.  Does the price paid for that option change the decision to sell?  Would you sell if the cost were $2 but hold if you paid $7?  If 'yes,' then you don't understand trading. 

When you no longer want to own a position then don't own it.  Do not hold just because it would result in a loss if you were to sell.  You already lost the money, and holding invites a larger loss.

Bottom line: You either want to exercise your option, or you don't.  You either want to sell your option, or you don't.  The price you paid is ancient history and 100% immaterial.

4) If the time value is negligible, then there is no theta to be 'eroding fast.'  Theta is the erosion of time value.

5) I would never change my mind.  Period.  Exercising a call option is stupid (exceptions noted above).  Just take that as gospel.  It is stupid.  Just sell it when you don't want to own it.  Interest rates do not matter over a two-day period.  But why own stock for two days?  Don't exercise.

6) If the option bid is less than parity (i.e. if you cannot get at least a fair price for the option), then it is possible to exercise and IMMEDIATELY sell stock.  But this involves extra commissions and is probably still a bad idea.

It is NOT the bid/ask spread that matters.  If the stock is 60 bid, you can sell stock at 60.  If you own the 50-call and the market is 10 bid 14 asked, what difference does that make to you if the market is wide.  If you can sell at 10, that is easier and less expensive than selling stock.

If however, the market is 9.90 to 10.10, that's a nice tight market, but does you no good.  You want to sell the call at $10.  So yes, in this example, you may exercise and immediately sell stock.

Exercising calls to own the shares is a trade made by someone who should not be trading options.  One more point – if you were to make the mistake of exercising early, why would you do it in the morning?  Wait until the close of trading.  It is possible that the stock will decline 20 points that day and you would be left holding the bag.  Exercise instructions are irrevocable.

Amit,

I have a problem when responding to question such as these.  If you have been trading for a two years, then none of this should be unknown.  On the other hand, if you have been trading two months, then it is reasonable for you to have not yet considered these ideas. 

When replying, I do not know to whom I am addressing the answers.  It can be someone who just doesn't get it, or it can be to a very eager to learn beginner. 

743

Open an account at Trade King, get all transfer fees reimbursed, get a year's subscription to Expiring Monthly.

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