When not to exercise a call option

I generally take the approach that there is no such thing as a dumb question.  If you don't understand something, there's a good chance that others will also be in a quandary over the identical question.  However, I am reconsidering.  The second question below – and I have seen it many times – is truly a dumb question.

 

Mark,

Thanks for revisiting this topic.

What if I want to buy and sell calls but don't want to sell my current shares. Is there anyway to avoid this?

If I am selling covered calls, and the stock hits the strike price, isn't it almost a given that the stock will be called away from me and sold at the strike price?

Mike

***

To Mike,

1) Yes, there is a way to avoid selling the stock. One simple method is to hold the long stock shares in a different account.
Then if you are assigned an exercise notice you will still own the shares in one account and be short shares in the other account. You can repurchase those short shares whenever you want to do so and remain long the original shares
2) Of all the questions that I receive – and I appreciate each and every one of them – this specifc questions bothers me more than any other.  I get it repeatedly and cannot understand how that is possible. 
Warning: Anyone who asks this question should not be trading options.  Not now, and possibly not ever.
The most basic concepts of using options involves some consideration of how options are priced and what they are worth.  No one in his or her right mind would ever – and I mean ever – exercise a call option just because the stock 'hits the strike price.'
There are so many reasons why this is true that it painful to attempt to list them. Here are two.
a) Your question assumes that writers of call options only sell options that are out of the money.  Let me assure you that many traders sell options that are already in the money – and that means the stock has hit the strike price – even before the option was sold.
I, for one, would never write an out of the money covered call, preferring to always take the more conservative path of writing in the money call options. let me assure you that I have never been assigned the day I sold the options, even though the stock has already 'hit the strike price.'
Virtual guarantee

b) If the stock hits the strike price, it's almost a 100% guarantee that your option will NOT be exercised under those circumstances.
Do you want proof? Look at any stock that is above the strike price of a given call option.
For example, yesterday AAPL closed at $309.52. 
Look at the open interest for Nov 300 calls.  Is it zero?  Did everyone who was long that option exercise it when AAPL passed $300 on the way up?
Look at AAPL Nov 290 calls. Is the open interest zero?  Did everyone exercise his/her long AAPL Nov 290 calls when the stock moved past that price?
Is that open interest anywhere near zero? Does it look as if everyone who was long that option exercised?
Now kook at the price of the Nov 300 call.  If the call owner exercises he owns AAPL at $300 per share when it's trading $9.52 higher. Exercise and your call becomes worth $952.
Do you see that the call closed trading yesterday near $19?  If you sell that call, you collect $1,900.  Would you prefer to have $952 or $1,900?
Isn't it price far above the option's intrinsic value? Don't you understand that if the option were exercised the owner would lose every penny of that time premium?
If you do not understand every word of the explanation above you have no business trading options. You have no idea how options work and have zero chance – outside of good luck – to earn any money.
Learn the basics. Then trade.
3) I ask a favor: Where did you get the idea that the option would be exercised under the conditions stated? Please write again and tell me who is teaching people that this absurdity is within the realm of possibility.
816


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11 Responses to When not to exercise a call option

  1. Huy 10/22/2010 at 8:51 AM #

    Seeing as this site is called Options For Rookies, your reply to Mike seems a bit harsh, unless his level of understanding can be considered pre-rookie (if there is such a concept).
    If there is one thing that I learned from reading your blog, it is that being assigned a covered call option is a good thing. When I first started using covered calls, I would be afraid of being assigned, because I didn’t want to lose my position — I just wanted to collect the premium. Then you wrote in your blog about being exercised, “if you wrote a covered call, the position has been closed, you earned the maximum possible profit from the trade”. That simple phrase provided so much clarity for me. “Earning the maximum possible profit from the trade” implies you have a plan, you executed the plan, and by being assigned the plan is realized.

  2. DC 10/22/2010 at 10:45 AM #

    Hi Mark,
    I have a few questions on option liquidity that I was hoping you could clarify for me:
    1) Before I enter a trade, should I look at the options volume of the strike I am buying (or selling) to determine whether that option is liquid? Or should I be looking at the option’s open interest? Or a combination of the two?
    2) Should the bid/ask spread also be taken into account to determine how liquid the option is? Also, typically, how tight should the bid/ask spread be for the option to be considered liquid?
    3) If I am interested in entering a spread trade (e.g. a vertical credit spread) and one of options in the spread has very high volume and very high open interest, but the other option does not, would it be a good idea to look for a different spread where all the legs are liquid?
    4) I have seen strikes with very high options volume but very low open interest. Does that mean that the options at those strikes are not liquid enough because the open interest is low (even though the option volume is high)?
    5) Which one of the two indicators (option volume or open interest) should I be looking at before entering a trade in order to ensure that, if I need to close out the position, that will happen quickly and at a good price?
    6) Are there any rules in the exchanges that limit how wide a bid/ask spread can be? For example, if I enter a trade when the bid/ask spread is fairly tight and then, due to lack of liquidity, the spread gets wider, is there a maximum limit to how wide that spread can become? Also, is there a risk of not being able to close out that position due to lack of liquidity?
    Thanks

  3. Mike 10/22/2010 at 11:53 AM #

    Mark, thanks for writing an answer to my question. Although I am not a rookie anymore, I still do not always clarify what I mean to say, i.e. expiration and strike price.
    I understand that the option can be exercised at expiration. AT EXPIRATION. I understand it, I get it. But at what price will it be exercised at? The strike price, right? I might not have been clear in what I meant to say, but that is what I meant to say.
    Yes, I was unclear about my choice of words. If anything in the above paragraph is incorrect, let me know, because then I really do not get it.

  4. Mike 10/22/2010 at 12:00 PM #

    Followup on covered calls: And as the option gets closer to expiration, is there a way to avoid exercise? What if I want to keep the stock and don’t want to have it called away.
    Mike

  5. Brandy 10/22/2010 at 12:46 PM #

    If it’s a frequently asked question, then it needs to be answered frequently. What rookie would want to email a question to (let alone hire as a mentor) a teacher who blows up and sneers at the student? Suggestions: take a deep breath, respect your students, and remember these people don’t have all the pieces worked out before they come to you. This isn’t the first time you’ve gone ballistic on a student who was merely trying to get clarity. An apology is in order, and some introspection, too.

  6. Mike 10/22/2010 at 4:21 PM #

    Thanks, Brandy, but I didn’t take it personally, so an apology is not necessary. If anything, I’ll probably not forget. Then again, I still sometimes think there are 52 states! And my 8th grade teacher’s attempt to humiliate me failed to teach me a thing.

  7. Mark Wolfinger 10/22/2010 at 8:59 PM #

    To Brandy and Huy,
    1) You are correct. It was a harsh response.
    2) What you don’t know is that this Mike has already asked this same question at least three times. I did neglect to mention that fact in my original response.
    3) I have a lot of patience when it comes to helping people learn about options. However, to be repeatedly asked by the same person: “Doesn’t a short call position get assigned as soon at it moves ITM?” is beyond my ability to maintain my composure.
    More than that, options are not for everyone.
    I apologize to any readers who may have been offended. But I offer none to Mike, who refuses to tell me where he got this idea in the first place (I asked each time this specific question was asked).
    Someone who cannot grasp the concept that options carry a time premium, or who cannot understand that exercising a call option earlier than necessary turns a limited risk play into a position with considerable downside risk – is simply not equipped to trade options.
    There is some blind spot in his perception that tells me this guy has no chance to make money with options. If he cannot get this simple basic idea, how can he ever learn to trade? To me, it’s a waste of time.
    And more than the fact that options are beyond his understanding, I am offended that he gets to ask the same question – and each time pretends he has never asked before.
    Sure I want to teach and mentor traders, and yes, I must show them that I have the mental stability to do the job – but when someone asks this question of me (several times), it can easily give the impression that this is one of my students who learned nothing. I’m trying to protect my business by not allowing anyone to believe that a student of mine can be this obtuse on a topic as basic as this.
    That’s my story and I do apologize to anyone who was offended. But I do not want to see this question posted again and am doing what I can to dissuade Mike from asking this question again.
    I’m happy to answer any other question he may ask.

  8. Mark Wolfinger 10/22/2010 at 9:02 PM #

    Mike,
    When any option is exercised, the transaction (purchase or sale of the underlying) is ALWAYS transacted at the strike price.
    Thanks for understanding. In this case your statement is correct.
    Best regards,

  9. Mark Wolfinger 10/22/2010 at 9:12 PM #

    There is only one way to guarantee not being assigned an exercise notice on a call (or put) option that you sold: Buy it back. That purchase cancels the sale and you can no longer be assigned.
    To avoid exercise, and not go so far as to guarantee that you will not receive that exercise notice, you can wait until a couple of days prior to expiration before buying that option. If you choose this path, there is still a small chance of being assigned.
    If the stock pays a large dividend and if the option has a delta of 100 and has zero time premium, then you will have to buy it back at least one day before the stock goes ex-dividend.
    Note, when you buy it back, if you still want to be writing covered calls, that’s the appropriate time to sell a new option – presumably at a higher strike price (because you don’t want to be assigned an exercise notice), and with a later expiration date.
    But Mike, I offer this suggestion: If you do not want to sell the shares, then writing covered calls is not a good strategy. Covered call writing is designed for investors who are perfectly willing to limit upside profits in return for collecting a cash premium today. This is a decent strategy, depending on your investing goals, and it is not for everyone.
    So ask yourself BOTH: Why don’t you want to sell the shares? Why are you selling call options?
    Between these two questions and your replies, you ought to be able to decide whether writing calls is appropriate – for this stock. You can write covered calls on others stocks – when you are not so determined to hold them.
    Regards

  10. Mark Wolfinger 10/22/2010 at 9:30 PM #

    Hello DC,
    Good questions.
    Will post a reply as a separate blog post earnly next week
    Regards

  11. Mark Wolfinger 10/22/2010 at 9:31 PM #

    Thanks for the comment Brandy.
    Regards