Understanding Option Basics

In this post I painstakingly explain one of the most basic option basics to a reader who is having trouble understanding that concept.

Mark,

Here is my follow-up question (original Q &A are here):

Jeff,
I am here to help you understand how options work, but am at a loss as to where to begin. I’ll explain in the simplest possible language. I am not talking down to you. I am trying to get you to move past a mental block.

FACTS

1) Any time that an option is in the money (ITM) at expiration, expect that its owner will exercise. Even when it’s ITM by one penny.

2)The option owner must fill out and submit a DO NOT EXERCISE form to prevent the Options Clearing Corporation from exercising ITM options

Many beginners do not know they have the choice to not exercise

Many beginners forget they own the options or forget that expiration has arrived. As a result, they become owners of stock that they do not want, and cannot afford to purchase

Many beginners make mistakes. Let’s minimize yours.

***

Call strike price + premium paid = break-even

I’ve placed your equation in bold. It is of vital importance that you understand one thing about that equation:

    This equation, all by itself, is the cause of your problems

. Forget it. It has no relevance on whether anyone exercises an option. Your formula is fine for keeping records, after the trade is closed. It is unimportant now. More than that. It is currently causing confusion and limits your ability to recognize the truth.

Using such a formula, does it follow that when the stock price is less than the break-even, then the call would not be exercised? For example, if at expiration the stock was $15.05 and one had purchased the $15 strike for a $0.10 premium, it seems one would not exercise the option.

No, it does not follow. If you ignored your break-even equation, you would never ask this question. You believe the owner of your call option would throw away $5, just because it represents a loss! Look at it from the perspective of someone who owns 100 calls. They are worth $500 to the trader.

You are saying that it ‘seems right’ for trader would throw away $500 because he paid $1,000 for that investment. No one in his right mind would do that.

To clarify: Have you ever sold stock at a loss? Did you consider telling your broker to take the shares out of your account and to give them to some randomly chosen person? Instead of taking current value for your stock, you could have chosen to make them worthless to yourself. Surely you know not to do that. When taking a loss, you recover some money. Your money. This situation is no different.

You must not toss cash in the trash just because the trade is at less than break-even.

If you lost a $10 bill and the next day found a $5 bill, would you refuse to pick it up because your loss was a larger sum? This is exactly the same. You must understand this principle. I don’t know how to make it more clear. Those options are worth $5 apiece and only an idiot would elect not to collect cash for them. [Exercise is a different decision and trust me when I tell you that selling is better for you.] Whoever ends up holding those options will exercise at expiration.

There is a tiny [my guess is less than one chance in 10 million] that an option ITM by five cents would not be exercised by its owner. But, it remains a possibility. People do make mistakes.

Yet I have read that options will be exercised if the stock price exceeds the strike price at expiration [MDW: this is only true for calls; for puts the stock must be below the strike], which it does in my example. It makes me wonder if there are other factors being considered by the call buyer. One rule, which I assume is adopted by the industry, is that all options in the money at expiration by $0.05 or more are automatically exercised, unless otherwise directed. What other factors could cause calls to be exercised below the break-even detailed above?

Yes, automatically exercised. The OCC does not care about break-even. Nor should you. Today the number is ITM by $0.01, not $0.05.

You want to know what other factors would make someone exercise when that exercise (or sale) results in a loss. Here’s the answer: MONEY.

When you invest or trade, it is inevitable that you will have losses. When you have a loss, you do not have to lose every penny. The trader is allowed to sell (or exercise) to recover some money. You probably understand that process. However, when expiration comes into the picture, you ignore what you know because you think about that break-even nonsense. When you fail to exercise (or sell), you allow the option to expire WORTHLESS. Why would you take zero for an option that you can sell for $0.05? Answer that one question (correctly) and you will understand.

How can the original cost matter? That’s your hang-up. That break-even is bothering you. Today, right now, you have a choice. Take $5 or take zero. It’s as simple as that.

Perhaps my question was misunderstood. I discussed selling the call rather than at what stock price a call owner will exercise. I understand and agree with you that it is better to sell your call for any amount rather than let it expire. I also understand what you mean by saying the premium paid is meaningless. Yes, if your plan was to sell the call and not exercise it then the premium paid is meaningless in terms of deciding whether you are going to sell the call or let it expire.[MDW: If you understand that, then why are you asking?]

(However, the premium is not meaningless if you want to determine if your trading strategy is successful as it represents part of your investment.)

I did not misunderstand. The premium is meaningless, as you admit.

You continue to look at useless items. You think record keeping and evaluating your strategy play a role in this discussion. They play no role when it’s time to make a trade decision. They are used after the fact to see how well you did. [If you disagree, and I have no doubt that you do, that discussion is for another time]

Also, I think you misunderstood my example when I said the stock price was $15.05 and I had a call with a $15 strike for which I paid $0.10. This was interpreted as the stock was trading at $15.10. Perhaps the price relationships I used in my example would not exist in the market. I apologize if I improperly set my example.

When you buy the call at ten cents, and eventually exercise, then you buy the stock at the strike price ($15) per share, but your cost basis is $15.10. You did not improperly set your example. Nor did I misunderstand.

Even so, I am encouraged by how you ended your response: “In this scenario you should almost never want to exercise”. This indicates to me that the risk of owning the stock, plus the additional investment required, must produce a greater return than displayed in the example before exercising the call becomes likely (at least for you).

No, not for me. For everyone. You made an investment. You sought a certain return. You did not earn that return. so what? Today is decision time: You take your $5 or you don’t. ‘Return’ no longer applies.

You are confused because you are looking at too many variables

You are concerned with break-even. You are worried about whether your strategy is working. You think about producing ‘a greater return.’ NONE of that matters at the time when the call owner decides what to do with the options: sell, exercise, discard. You either take the $5 or you don’t. It’s that simple. There is nothing else to consider. The fact that you have irrelevant items on your mind is the reason this is a problem.

I’m still left not knowing at what stock price / strike price combination calls are usually exercised. [MDW: Of course you know. When the stock is at least one penny in the money options are exercised.] I suppose as a buyer it would be when the stock price is greater than the strike price plus the premium. [MDW: NO] As a covered call seller it probably would be best to assume it would be when the stock price exceeds the strike price.[MDW: YES] Although this is not technically correct since a call’s price must be greater than zero to be sold, it’s probably good enough.

Calls are always exercised when they are in the money at expiration. Period.

There may be the occasional individual investor who correctly (for his/her situation) decides that exercising is too expensive because of commissions (and there were no bids when he/she tried to sell the call), but in general, all ITM options are exercised. That is all you or anyone needs to know.

Over the years, if (and only if) you can overcome your mental block, you may not be assigned a couple of times when the option is ITM by a penny or two. Just don’t expect it to happen.

I appreciate your efforts to help me with my question. I’m sure when my covered calls expire next week I will have an even better understanding that can only come from experience. Thanks again.

You are welcome. However, your entire conversation was from the point of view of the call owner. As the call seller you will learn zero about the mindset of the call owner. ZERO.

You must open your mind, throw out your misconceptions, and the truth will be right there in front of you. This is not difficult. This is the easy part. If you cannot understand this, there is no chance you can ever learn to use options effectively.

901

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8 Responses to Understanding Option Basics

  1. Mauro 02/14/2011 at 6:27 AM #

    Hallo Mark,

    Suppose the stockprice is 100 and i sell a 120 call. At expiration day the stickprice is 130.

    Will the call be exercised by an owner of the 120 call (that i sold) or is it possible that i have to give the shares at someone who owned the 100 or 110 call?

    • Mark D Wolfinger 02/14/2011 at 7:24 AM #

      Mauro,
      1) The option is 10 points ITM. It will be exercised. Guaranteed, 100%.

      2) Your option is a contract. Part of that contract is the strike price. That cannot be changed. You sell the shares and collect $120 for each.

      3) Someone who owns a 110 call gets to buy the shares by paying $110. However, that he buys the shares from someone who sold that $110 call. This will never be a problem for you.

      The strike price cannot be changed, nor can the name of the stock be changed. An option is a valid contract, and the contract remain valid until the option is ‘canceled’. That occurs under only two conditions:

      a) it expires worthless
      b) it is exercised

  2. Mauro 02/14/2011 at 8:33 AM #

    Thanks.

    Is it possible to tell something more about open interest and if we can profit by reading those number correctly.

    For exemple:

    When i see that the open interest of a particular option is zero and i see that someone sells a lot of put options (let’s say 50 contracts).

    We know that the buyer of those options is the market maker and when the put options are ITM he will deliver the seller of that option the 50.000 shares (50 contracts). So the market maker will buy those shares. This must have a big pressure on the stock price (when the daily volume of shares is not so big). So when we discover such a trader we can profit of what will happen by buying some calls. Of course in the ideal situation. 🙂

    • Mark D Wolfinger 02/14/2011 at 9:06 AM #

      Mauro,

      Thanks for the question. It seems to me that you are moving too quickly to be concerned with open interest.
      Please slow down and be certain that you understand the basic concepts of options.

      1) Some people believe you can accumulate valuable information by looking at the open interest. I am not one of them.
      To me, the information is pretty useless. If you Google the phrase ‘open interest’ or ‘open interest data’ you may find the opinion of people who use the data as market clues.

      2) 50 contracts is not a lot of options. 10,000 contracts is a lot of options And even that number is not so large when the underlying is SPY.

      3) 50 contracts represents 5,000 shares (100 shares per contract)

      4) The market maker is the person who buys the put options. That gives him/her the right to SELL stock. So YES, if the puts are ITM at expiration, he will sell 5,000 shares and it is the put seller who becomes obligated to buy the shares.

      5) The market maker does not buy 5,000 shares when he buys 50 puts. This can get complicated and this is not the space for a complete lesson. Let’s just say that the market maker will buy only enough stock to get delta neutral. That means, he multiplies the put delta by the number of puts bought and buys that number of shares. It may be 2,000 or 2,500 shares. It all depends on the delta of the put option.

      6) If this is a thinly traded stock, and buying a few thousand shares is difficult, then the market makers already know that and will not be as willing to buy 50 contracts as they would be when trading more actively traded stocks. The market makers take that into consideration when deciding how much to pay for puts. If they know it will be difficult to buy shares, they bid less for puts. Similarly, if they know it’s difficult to sell shares, then bid less for calls. Or what most likely happens is that the bid/ask spread gets wider.

      7) No, it is not an ideal situation. Just because someone who is unknown to you decides to sell 50 puts, that does not mean that the stock will move higher. the market makers may not buy stock. Instead they may hedge with other options in the same stock. Or they may hedge with index options. Or they may have partners who sit at computers and hedge the risk for them. Do not assume that the stock is moving higher.

      8. Most importantly of all: No one sees a change in open interest numbers until the next day. By then it is far too late to buy calls. And if these options and the underlying stock trade with low volume, you, as an individual investor must not be trading these issues. You want there to be some liquidity so that you can trade what you need, when you want to trade it.

  3. Mauro 02/14/2011 at 9:31 AM #

    Hallo Mark

    I indeed made a mistake. 50 contracts are 5000 shares. So i had to write 500 contract. 😉
    Sorry about that.

    Now i agree with you. I simplified the real world too much.

    Thanks for the comment!

  4. Mauro 02/14/2011 at 9:47 AM #

    Maybe it’s better to say that open interest CAN influence the stockprice when the daily volume is no so big.

    Let’s say, that a few hours before expiration the market maker own a lot of put options that he sold. These are OTM, so the delta is low and to hedge his portfolio he has just sold a few shares. But when the stock makes suddenly a big move and all those OTM puts become ITM, the market maker has to sell a lot of shares to hedge his obligation. So this can reinforce a certain movement?

    • Mark D Wolfinger 02/14/2011 at 10:04 AM #

      Mauro,

      Market makers do not trade like you and I trade.
      That hate risk.
      If the market maker is short any OTM puts as expiration approaches, they are hedged in some manner. And selling delta neutral number of shares is not how they do it.

      1) the best choice is to cover and eliminate all risk. I’m sure many do just that.

      2) The 2nd method is to turn the position into a reverse conversion: Sell stock, sell puts, buy calls (same strike and expiration). That is a position with no risk (other than pin risk), including no gamma risk.

      That’s how market makers trade. they do not hold such risky positions and do not reinforce stock movements.
      In fact they are far more likely to own extra OTM options for safety. Then when the stock rallies, they have the shares to sell vs long calls. When the stock falls, they have shares to buy vs. long puts. So, if anything, they tend to mitigate, not reinforce, a stock move at expiration.

      Regards

  5. Mauro 02/14/2011 at 10:19 AM #

    I unterstand now.
    Thanks again!