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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 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. 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 problem. 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. Q: 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. Q: 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. Q: 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] Q: 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. Q: 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. Q: 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. Q: 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. Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University. If you liked this article, visit our Options Trading Blog for more educational articles about options trading. Related articles: Can Options Assignment Cause Margin Call? The Right To Exercise An Option? Options Expiration: 6 Things To Know Early Exercise: Call Options Expiration Surprises To Avoid
What would make you wait for early exercise till Wednesday morning, Thursday morning, Friday morning of expiry week as a trader? Assume you have cash to buy all contracts. The time value is negligible, and theta is eroding it fast. Would you change your mind if the risk-free interest rate was say 8% and not 0-1% as currently? Is that rate a huge factor for 2-4 days anyway? I read some books where a bunch of math experts say that except for a dividend-paying underlying, early exercise is impossible. Personally, if I were the call buyer and I had bazillion money, I would not sell the calls as the bid/ask spread widens and the market makers play games. I would choose early exercise sometime on late Wednesday or anytime Thursday to remove option spread slippage, so I buy underlying at the strike price and immediately sell it to lock in profit, because underlying spread is narrower than the option spread. Answer: This is a very easy question. 1) I WOULD NEVER, exercise a call option prior to expiration – UNLESS it is to capture a dividend. Before I go further, there are three valid reasons why someone may want to exercise a call option early. My guess is that >99% of all option traders will never encounter these situations. If there is a dividend, sometimes a call owner must exercise the option or it is throwing money into the trash. The call must be ITM, the delta must be 100 and the option should not be trading over parity. A professional trader (market maker) may prefer to sell stock short to hedge some trades. If he/she does not own long stock, then when expiration is near, deep ITM calls can be exercised and the long stock immediately sold. That is not as good as selling short stock, but must suffice when there are no better alternatives. When expiration is near and the call option is deep ITM, sometimes the option bid is below parity. In that situation – and it is not that common because most traders do not hold onto options that move deep into the money – then it's often better to exercise and immediately sell stock than it is to sell the call. Selling the call is preferable because it saves commission dollars. But if the bid is too low, then the trader may have to exercise. These situations exist, and I mention them for the purist. However, my contention remains that if you are a retail investor, you can easily go your entire lifetime and never exercise a call option – or have any reason to do so. A smart retail trader NEVER exercises a call option. What can be gained? Think about it. Why would anyone prefer to own stock and suddenly have downside risk. If you are assigned an exercise notice on a call option prior to expiration, consider it to be a gift (unless you cannot meet the margin call). 2) If I no longer want to own the option, I sell it. You seem to arbitrarily hold options until Wed/Thur of expiration week. That is terribly foolish. The ideal time to sell an option is when YOU no longer want to own it – not on an arbitrary calendar date. 3) The price paid for the option is 100% irrelevant. I don't know why so many people get hung up on this. Assume you own a call option and the price is $6. Assume you no longer believe the stock is moving higher. Does the price paid for that option change the decision to sell? Would you sell if the cost were $2 but hold if you paid $7? If 'yes,' then you don't understand trading. When you no longer want to own a position then don't own it. Do not hold just because it would result in a loss if you were to sell. You already lost the money, and holding invites a larger loss. Bottom line: You either want to exercise your option, or you don't. You either want to sell your option, or you don't. The price you paid is ancient history and 100% immaterial. 4) If the time value is negligible, then there is no theta to be 'eroding fast.' Theta is the erosion of time value. 5) I would never change my mind. Period. Exercising a call option is stupid (exceptions noted above). Just take that as gospel. It is stupid. Just sell it when you don't want to own it. Interest rates do not matter over a two-day period. But why own stock for two days? Don't exercise. 6) If the option bid is less than parity (i.e. if you cannot get at least a fair price for the option), then it is possible to exercise and IMMEDIATELY sell stock. But this involves extra commissions and is probably still a bad idea. It is NOT the bid/ask spread that matters. If the stock is 60 bid, you can sell stock at 60. If you own the 50-call and the market is 10 bid 14 asked, what difference does that make to you if the market is wide. If you can sell at 10, that is easier and less expensive than selling stock. If however, the market is 9.90 to 10.10, that's a nice tight market, but does you no good. You want to sell the call at $10. So yes, in this example, you may exercise and immediately sell stock. Exercising calls to own the shares is a trade made by someone who should not be trading options. One more point – if you were to make the mistake of exercising early, why would you do it in the morning? Wait until the close of trading. It is possible that the stock will decline 20 points that day and you would be left holding the bag. Exercise instructions are irrevocable. Related articles: How Index Options Settlement Works Can Options Assignment Cause Margin Call? Options Expiration: Six Things To Know The Right To Exercise An Option? Want to learn more? Start Your Free Trial
Dave W posted a topic in General Board@Yowster or others, I'm hoping to get some advice. I occasionally trade unofficial hold through earnings (HTE) calendars and have run into a recurring issue. After earnings, sometimes the price jump in the stock results in my calendar becoming deep in the money. When I try to close out the deep ITM calendar, the market makes it very difficult or impossible for me to close out at a reasonable price. For example, this recently happened to me on RHT. I had an 82C calendar spread March 31 short / April 7 long and at the close before earnings on March 27 the stock price was $82.32. About an hour after the open on March 28, RHT stock was at $86.93. So my 82C were $4.93 ITM. But the mid-price to close out the spread was in a kind-of 'backwardation' (yes, I know that isn't the exact right term, but the situation seems similar). The mid for the short leg was $5.00 and the mid for the long leg was $4.90, so a debit of $0.10 to close the spread. Paying a $0.10 debit to close the spread (or even closing at $0.00) seemed unreasonable given that if I held the short leg through expiration, any premium to close the short options would be gone and hopefully the long option would recover some premium ($0.10 to $0.15 based on my review of other RHT options in different time periods). So I held the spread through expiration and got assigned. I closed out the position the following day using a combo stock / option order on TOS. I'd like someone who has done a number of these HTE trades to help me understand: 1. Has this ever happened to you? How would you recommend closing the trade when the price to close out the calendar spread is "way off" from what seems reasonable (e.g., having to pay a debit to close)? 2. If I do hold through expiration and get assigned, am I still 100% covered by the long option? In other words, will the changes in the long option prices offset changes in the short stock position exactly? I'm guessing the answer is no, but I haven't really looked at this yet and am not sure the best way to model it. I appreciate the advice. Thank you!
Every so often I receive a question or comment from an option trader that makes me realize something: No matter how basic the explanation, there may be something else going on that causes confusion in the mind of that trader. For example: A trader sells an option, eventually covers the short position and asks whether it is still possible to be assigned an exercise notice. We all know the answer is: ‘NO’ You cannot be assigned an exercise notice when you are no longer short the option. So how can this become a problem? In my opinion it stems from the fact that all our definitions are not quite 100% clear. In this instance, the option owner still retains the right to exercise. However, our definition clearly states that someone who sold that option can be assigned an exercise notice. What is missing is a clear distinction that the obligation is transferred to the new seller when the original seller covers (purchases, in a closing transaction) that position. Bottom line: Only the option owner may exercise; only someone with a current short position can be assigned. Pretty simple concept, but occasional questions arise. A more recent example: I thought spreads were a single trade, and couldn’t be “picked apart. The trader was disconcerted when assigned an exercise notice on the option sold as part of a spread. There are several basic points to be addressed. Yes. The spread is a single ORDER and cannot be picked apart. When you enter a spread order, you are filled on ALL PARTS of the order, or none. It cannot be picked apart. Once the order is filled, the trader owns a spread position. As far as you are concerned, this is a single (hedged) position and you intend to trade it as such. However, the rest of the options universe does not know anything about you or your plans. The OCC (Options Clearing Corporation) knows nothing about you either. Sometimes the conversion of an option into stock can result in a margin call. That is a real problem, especially when the broker gives the customer 10 minutes to meet that call. [some years ago, traders had a few days.] What the OCC does know is that you own option A and that you have a short position in option B. Nothing else matters. Why? When any person exercises an option, the OCC verifies that the person has the right to exercise (i.e., that person owns the option). Next the OCC assigns that exercise notice to a randomly-chosen broker. The broker finds all of its customer accounts with a short position in that option and via specific process (usually random selection) chooses an account to receive that notice. No account is immune. No account owner can say that he/she was hedged and is therefore exempt form being assigned. Once that assignment notice has been received, the deal is final and cannot be undone. In our example, the customer sells 100 shares short and receives the strike price in cash. Consider this possibility: A new option series is listed for trading. That day, the option never trades – except for one spread order. If the option seller were exempt form being assigned, then the option owner would not have the right to exercise, and that is not possible. In the specific situation involving the person who send the question, he was trading in an IRA account. Under no circumstances may anyone be short stock in an IRA, so he was required to fix the situation immediately. He elected to sell his long option and buy the short stock. He could have re-established the original position (risking another assignment) by buying stock and selling the same call sold earlier. Early assignment is not always a a problem. However this time a short stock position was in an IRA account and the trader was forced to exit the stock position. Being unable to meet a margin call is always s distinct risk when trading options. Using European-style index options eliminates that risk, but significantly reduces your vehicles for trading. Bottom line: If you are short an American-style option, you may be assigned at any time. Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University. Related articles: How Index Options Settlement Works Can Options Assignment Cause Margin Call? Options Expiration: Six Things To Know Want to learn more? Start Your Free Trial