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Q & A. Exercising, trading, and investing with options

Scott is continuing a conversation begun earlier

Below, he has clarified some questions and raised new points that are worth discussing.  Link to the
above post to read the entire discussion from the beginning.


Mark,

I appreciate the time you took to respond to my questions – questions
that after rereading the following day I realized were poorly written. And in
reference to a few of your comments, no, I have not begun trading options with
real money—thanks for your concern. I’ve done well trading stocks and thought it
time to learn about options.

***

Below are pertinent excerpts and my replies.  Scott's comments and questions are in bold.

***

1) Is your understanding that you can always earn a profit when buying options?

No; I’ve read that more than 75% of options expire unexercised.

The figure about options going unexercised (expiring worthless) is false and misleading.

That 75% (I usually see a higher estimate) number refers ONLY to those options which are still open when
expiration arrives.  Many – dare I say most? – of the options that have
value – have already been closed.  That means the original
option buyer may have taken a profit or loss, but he/she is unlikely to continue to own that option all the way to expiration.  This applies to the sellers as well.  Those closed option trades are ignored by those who publicize the statistic you quote. 
This results in too many people believing the incorrect numbers.

Example: If the open interest is 100, and 80 are closed prior to
expiration, that leaves 20.  If 15 expire worthless, the figure you see
as expiring worthless is 75%, not 15%.  The 75% is a statistical lie.

***

I have a question for you: Why are you mentioning the idea that you 'could
exercise' the option? Did you 'learn' that exercising is a reasonable choice?


In each source that I’ve read they spend equal amounts of time discussing
the two choices available if the underlying stock advances past the strike
price: 1) resell the option for a slight profit, or 2) exercise the option and
either sell or hold the stock. From what I understand, the second option seems
to be more advantageous if my plan is to purchase and own the stock in the long
run. With this choice, if I am right I may able to purchase the stock at a
slight discount and if I’m wrong and the price plummets, I am only out the price
I paid for the option.


Most call buyers do NOT want to exercise a call option and take possession of the shares for the
longer term.  They prefer to trade the options and earn a profit (or
take a loss when necessary).
  That doesn't mean choosing to exercise is wrong for you, but think about the cost.

Consider this:  You can buy stock today at
28. Or you can pay a premium to buy a 3-month call option with a strike price of 30.

If you buy the call, your downside loss is very limited.  And that's good.  But, if you are considering exercising the option if it moves past the strike price (and remains there until it's time to exercise), It seems to me that your choice comes down to paying $28 today, or $30 (plus the option cost) later.

There has to be a very good reason why you would not want to pay the reduced price today.  One such reason for taking this stance is that you are not going to be bullish on this stock unless it breaks out by trading above 30 You are buying the option because you expect it to rally very quickly once it breaks out.  And if it never does that, you don't want to own the shares.

Most investors who plan to exercise a call and take possession of stock would benefit by buying
ITM, not OTM options.
  Yes, you can lose more if the stock declines, but if it's your intention to become a shareholder, the purchase price matters.

One more point. I don't consider buying an out of the money option and later exercising – to be buying the stock at a discount.  It may be a discount to the price at the time you exercise, but you paid dearly by not buying stock today.  This is paying more for the stock than you should be paying.

These are the major reasons that option buyers are not usually interested in buying (or shorting) the shares.  Option buyers tend to trade for profits.

Bottom line: Decide why you are buying the options and the best way to achieve that goal, while paying attention to risk.

***

When you own an
option, you have the 'right' to exercise. But more importantly, you have the
right NOT TO EXERCISE. So once again, I ask, why are you considering exercising
the option? Did you read that exercising is to your advantage?


Several sources mention that most options are exercised when they are
in-the-money by $0.05 or greater, especially if the buyer believes the
underlying stock will continue to rise.

Those sources are referring to what happens when expiration arrives.  When discussing exercise choices, omitting that detail is criminal, in my opinion.   Almost all options that are in the money (ITM) by one penny or more are exercised – at expiration.  Not before.  Occasionally an investor may elect not to exercise an option that is barely ITM.

But the point is:  They are referring to expiration, and only expiration.

to be continued

512

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