Options Education - In and Out

 Options educational content provided courtesy of ChartBender.

Options In & Out explains the alternative methods for exiting long and short option positions.

There's only one way to get into a long position: you have to buy the option(s); that is, "buy to open" the position. That's all there is to say about how to enter a long position. However, once you've bought an option, there are three ways in which you can exit your position:

1. Exercise the option
2. Close the position by selling the option
3. Let the option expire

The method you decide to use for exiting is up to you. In this section, we'll talk about some of the considerations for making that decision.

Let's say we are going to buy the XYZ Jan 35 Call option depicted in the graph to below. The graph tells us the following:

• We Pay: $2.50 for the call option (in this example, we are excluding the time value.)
• We Pay: $35 for the stock when we exercise the call option (because $35 is the strike price of the option)
• Thus, our total cost (break-even point) is: $2.50 + $35 = $37.50 to acquire a stock that is trading for $37.50.

Here in example 1, we did not consider the impact of the option's time value. As a result, our total cost to acquire the stock by exercising the option is equal to the current market price of the stock. We got the power of owning the option without paying anything extra for it. In reality, however, to get the rights and leverage provided by an option, we will have to pay a premium. That's where time value comes in. See Exercise, part II below.

Now let's add the time value back in and look at the cost breakdown if we exercise the option:

• We Pay: $3.50 for the call option (here we're paying $1.00 more because we've added the time value back into the price of the option)
• We Pay: $35 for the stock when we exercise the call option (because $35 is the strike price of the option)
• Total Cost (break-even point): $3.50 + $35 = $38.50 to acquire a stock that is trading for $37.50.

To purchase this option, we paid a $1.00 premium over the current XYZ stock price. If we plan to exercise this option, we have to offset the extra $1.00 in cost. This is why we need the stock price to rise another $1.00 to $38.50. When the stock price hits $38.50, we could exercise the call option, get the stock for $35 per share, and then sell it immediately for the market price of $38.50. That would let us break-even. To profit, the stock price would have to go above $38.50.

Selling The Option
Lack of exercise can make your wallet fat. In practice, we never exercise our long options. This is because we can always profit sooner and bigger by simply selling the option.

Profiting Sooner Let's say we buy the XYZ Jan 35 Call for $3.50 when the stock price is $37.50, as indicated in the graph to the right. The graph tells that our exercise break-even is $38.50. But we're not exercising the option this time. We just want to sell it.
Assume that the price of XYZ stock goes up to $38.00, as indicated in the second graph to the right. The option responds by going up $0.20. We paid $3.50 for our XYZ Jan 35 Call option, so we could now sell it for $3.70. That's a $0.20 profit on the option from a $0.50 move in the stock price.

In contrast, if we wanted to get a $0.20 profit by exercising our option, we'd need to wait until XYZ stock went up $1.20, to $38.70. Remember, our break-even point when exercising is $38.50. So we'd need another $0.20 increase above the break-even for a $0.20 profit. Why hold out for a $1.20 move in the stock price when we can get the same profit from a $0.50 move by just selling the option? We can profit sooner by selling the call than we could by exercising the call.

Profit Bigger

The graph to the right shows the price of XYZ stock increasing from $37.50 in the first graph, to $39.00 in the second graph. In this case, XYZ stock has gone up above the exercise break-even point of $38.50, allowing you to exercise the call profitably.
Would it now be better to exercise the option as opposed to selling it? Not a chance! If we sell the call, we make an $0.80 profit because we paid $3.50 for the option and we sell it for it's current price of $4.30.

If we were to exercise the option, the outcome is not as good. The exercise break-even was $38.50 (top graph). By exercising the option when the stock price is at $39.00 (bottom graph), we would acquire the stock for a total cost of $38.50 per share. To get our profit, we immediately sell the stock for the current market price of $39.00. The profit is $39.00 - $38.50, which is $0.50.

It's a no-brainer. It is always more profitable for us to sell options outright as opposed to exercising them. But why? The reason is because whenever you exercise an option, you forfeit any remaining time value the option has. Looking at the graphs above, the time value is the red portion. You are giving that a way when you exercise. To whom are you giving it? To the person on the other side of the trade: the short seller of the option! In contrast, when you sell the option, you get paid the full price of the option, which includes any time value.

If an option is out-of-the-money upon expiring, it will have no value. There is no reason to pay the commission to sell a worthless option just to close the position. You'll just let it expire and be done with it.

*Check with your broker to see how deeply in-the-money options must be to trigger their auto-exercise feature.

Next:Getting In and Out of Short Positions

This educational content is provided by ChartBender.
© 2005 ChartBender, LLC.