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More: When not to Exercise a Call Option

Yesterday's post collected a variety of comments and I thought an extended reply is in order.

One more reason why it's bad policy to exercise a call option when it first moves into the money.

1) It's a money-losing strategy with nothing to gain

Let's say that a trader wants to buy stock when it hits $60 per share or higher.  The reason is not important, but let's agree that this price represents a technical breakout and the trader wants to get long at that price.


Buy Stop

The correct procedure is to place a (market) buy stop order.  By taking this action, the trader's broker issues a market order to buy the designated number of shares the instant that the stock trades at $60 or higher.

We know two things about this trade:

  • The price will be $60 per share, or perhaps a couple of pennies higher
  • If the stock never trades as high as $60, then the trader loses nothing and never buys the stock

 

Buy Call

Compare the actions of an options trader who has not yet learned his lessons about when to exercsie a call option.  With the same expectations as the trader who uses the buy stop order, the options novice buys call options (with a 60 strike price) and pays $300 apiece.

What happens? 

If the stock never gets to $60 by the time the options expire, the trader is out $3 per share.  Not one penny of that money was wisely invested.  It was a total waste.

It the stock does get to $60 and the trader immediately exercises the call option and own the shares as planned.  However, the cost is $63 per share.  In other words, this trader deliberately spent $3 more per share than necessary.

How can this be a good move?  No one makes this trade – unless the trader does not understand the most elementary ideas about how options work.

But it's even worse.  Now that the call has been exercised, losses are no longer limited to $3 per share.  If this stock tumbles to $58, this trader is not only out the $3 per share paid for the calls, but also loses $2 per share on the stock price.

Everyone must understand options well enough to grasp this message:  There is nothing to be gained and there is much to be lost when a call option is exercised any earlier than necessary.  [More on this in a prior post.]

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