Exercising Your Option

[PowerBC]

Hi, I'm not that new to option theory but I have never done any option trading in reality and have a question about the mechanics of the process. I'm pretty up to speed on the concepts of buying and selling puts and calls, but something is bugging me.

Suppose you bought 100 contracts of April $2 calls for $0.05 each for some stock, XYZ, currently trading at $1.50. You're thinking that good news is on the way and the price could jump to $2.50. This cost you $500, 100 contracts and 100 shares apiece for $0.05. (Ignoring commissions, and that fact that this isn't a very good strategy, but bear with me for a minute).

Sure enough, close to the expiry date the spot price of XYZ is $2.50 due to some announcement, you've hit your target and you want to cash in. Apparently, the position you bought into is now worth (excluding time/volatility premium):

($2.50 - $2.00) * 100 * 100 = $5000 - $500 = $4500.

My question is, even though the position is clearly profitable, what if you didn't have enough money in your account to actually exercise the options? You'd need $2.00 * 10000 = $20000 to actually purchase the shares that are now worth $25000 that you could turn around and sell back to the market at spot price to realize the profit of $5000.

Would your broker just front you the cash, knowing that you are going to turn around and sell them immediately? Or would you have to arrange financing yourself before you could actually exercise your options.

 

[cvds16]

wow, you're as green as they come. You just sell the calls. Read lots and lots more before you even start to think about trading with real money.

 

[PowerBC]

You're right, amigo. I'm about as green as it gets around here... but thanks for clearing that up. I knew it was a dumb question, but now I know.

 

[dagnyt]

Quote from PowerBC:


Would your broker just front you the cash, knowing that you are going to turn around and sell them immediately? Or would you have to arrange financing yourself before you could actually exercise your options.

You already have the best answer: sell the calls.

But you did ask a different question. Yes, the broker lends you the money. And if you sell the stock the same day that you exercised your calls, you will not have to pay any interest on the cash borrowed.

But, there's more than cash involved. There is a margin requirement to buy 10,000 shares. That's a problem easily avoided - again, by selling the calls.

In general, you will NEVER want to exercise an option you own.

Mark

 

[cvds16]

well, there is one exception, if it is a deep-in-the-money call prior to dividend, but then again, most of the time you are just better off selling the calls, if it's really illiquid that might not be the case, but in practice it will be very hard to find such an example.

 

[dagnyt]

Quote from cvds16:

well, there is one exception, if it is a deep-in-the-money call prior to dividend, but then again, most of the time you are just better off selling the calls, if it's really illiquid that might not be the case, but in practice it will be very hard to find such an example.

There are other exceptions, but the OP is not ready for any such discussions at this point.

Mark

 

[spindr0]

You're right, amigo. I'm about as green as it gets around here... but thanks for clearing that up. I knew it was a dumb question, but now I know.

I think we see more dumb answers than dumb questions here

 

[johnnyc]

Quote from PowerBC:

You're right, amigo. I'm about as green as it gets around here... but thanks for clearing that up. I knew it was a dumb question, but now I know.

wasn't a dumb question. nobody is born knowing these answers. most of the time selling the calls is your best solution but before you just blindly sell the calls, check the price of the calls against the price of the stock. would you make more $ by selling the calls or by exercising and selling the stock right away? there are some rare occassions when you would be better off exercising and selling stock instead.