Once again a reader (thank you Debi) asks about something that goes beyond the typical education received by option beginners.
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?
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?
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 There is no reason to hold them – and watch time decay kill their value – when your reason for buying the options is no longer valid.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
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.
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
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:
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.
Lessons of a Lifetime, an electronic book (.pdf file). My 33 years as an options trader.