Exercising options

Hi all,

I am currently researching options with the intent of begginning trading in a couple of months and had a few questions.

1. I understand that if you exercise a call you can place a sell order for the underlying securities at the same time and simply collect the difference between the strike price and the value of the security without ever physically holding the stock. Is it possible to do the same thing with a put option? I.e. Exercise the option and purchase the underlying security at the same time.

2. If it is possible to do this with a put, do you need the capital in your account to purchase these shares or does your broker recognise what you are doing and allow you to do this without the capital?
Likewise, if exercising a call and selling the shares immediately do you need to have the capital in your account to purchase the shares at the strike price?

The broker I will be using is Interactive Brokers if that helps.

The reason I ask this is because I was wondering what would happen if you have an In the money put/call and are unable to trade it and don't have the equity in your account to exercise the option. Is what I have suggested above possible such that it does not expire worthless.

Thanks for the help.

If you are "holding", that is have purchased a call or put, its simply a matter of selling it. *Has nothing to do with the underling share, you do not hold the underlying share.

Harro26 said:

Hi all,

I am currently researching options with the intent of begginning trading in a couple of months and had a few questions.

1. I understand that if you exercise a call you can place a sell order for the underlying securities at the same time and simply collect the difference between the strike price and the value of the security without ever physically holding the stock. Is it possible to do the same thing with a put option? I.e. Exercise the option and purchase the underlying security at the same time.

2. If it is possible to do this with a put, do you need the capital in your account to purchase these shares or does your broker recognise what you are doing and allow you to do this without the capital?
Likewise, if exercising a call and selling the shares immediately do you need to have the capital in your account to purchase the shares at the strike price?

The broker I will be using is Interactive Brokers if that helps.

The reason I ask this is because I was wondering what would happen if you have an In the money put/call and are unable to trade it and don't have the equity in your account to exercise the option. Is what I have suggested above possible such that it does not expire worthless.

Thanks for the help.

Click to expand...

You are creating additional transactions for no reason, there is no necessity to exercise. Simply sell the options before expiry (and can be on the day of expiry) and take your profit/loss.

Harro26 said:

The reason I ask this is because I was wondering what would happen if you have an In the money put/call and are unable to trade it and don't have the equity in your account to exercise the option. Is what I have suggested above possible such that it does not expire worthless.

Click to expand...

These are the kinds of questions you should be asking your broker.

NeuromanceR said:

These are the kinds of questions you should be asking your broker.

Click to expand...

Why is that ?

Procedural questions are for the broker.

Fellow ASF's are always more than happy to answer technical queries regarding options.

wayneL said:

You are creating additional transactions for no reason, there is no necessity to exercise. Simply sell the options before expiry (and can be on the day of expiry) and take your profit/loss.

Click to expand...

Thanks everyone. I thought it might be difficult to trade the option close to expiry, especially if it is heavily in the money. Who would buy these options?

Harro26 said:

Thanks everyone. I thought it might be difficult to trade the option close to expiry, especially if it is heavily in the money. Who would buy these options?

Click to expand...

Normally a market maker at, or very close to intrinsic value only.

cutz said:

Why is that ?

Click to expand...

Harro26 said:

Thanks everyone. I thought it might be difficult to trade the option close to expiry, especially if it is heavily in the money. Who would buy these options?

Click to expand...

Yep questions like that are easily answered here.

Harro26 said:

The reason I ask this is because I was wondering what would happen if you have an In the money put/call and are unable to trade it and don't have the equity in your account to exercise the option.

Click to expand...

But I interpreted this question as a procedural one.

I.e., "What happens if I can't close out my long calls/puts because I'm not able to access my broker for some reason. If auto-exercise kicks in and I don't have enough to cover, can I use same-day-substitution? If so, what would be the margin requirements?"

Thanks all for the replies.

One more concept I am struggling with - Due to Delta, an option is never going to rise in line with the price of the underlying security, if the stock goes up by $1 the price of a call for this stock might go up by 50c (At a Delta of .5). So what is the benefit of trading an option as opposed to exercising an option? If you can exercise the option and make an extra 50c/share in the above example (Or $500) why would you choose to trade this option instead??

Options are more complex than first thought, have just applied for an Interactive Brokers paper trading account which it seems will come in very handy.

Harro

Harro26 said:

Thanks all for the replies.

One more concept I am struggling with - Due to Delta, an option is never going to rise in line with the price of the underlying security, if the stock goes up by $1 the price of a call for this stock might go up by 50c (At a Delta of .5). So what is the benefit of trading an option as opposed to exercising an option? If you can exercise the option and make an extra 50c/share in the above example (Or $500) why would you choose to trade this option instead??

Options are more complex than first thought, have just applied for an Interactive Brokers paper trading account which it seems will come in very handy.

Harro

Click to expand...

If I understand your question correctly, that's not quite how it works.

Exersizing the option does not remove the fact that you have coughed up some extrinsic value (AKA time value) for it.

In fact, if you exercise an option where there is extrinsic value remaining, you immediately lose that extrinsic value. In all cases where there is extrinsic value remaining, (except where there is a financial benefit to exercise and capture a dividend) it would be better to trade out of the option to capture said value.

Even if for some reason you want the shares before expiry (and there is no divvie), and extrinsic value remains, it would still be better to sell the option and buy the stock in separate transactions... NOT exercise the option. Exercise only makes sense AT expiry, IF you want the shares ('cept for the divvie situation).

wayneL said:

If I understand your question correctly, that's not quite how it works.

Exersizing the option does not remove the fact that you have coughed up some extrinsic value (AKA time value) for it.

In fact, if you exercise an option where there is extrinsic value remaining, you immediately lose that extrinsic value. In all cases where there is extrinsic value remaining, (except where there is a financial benefit to exercise and capture a dividend) it would be better to trade out of the option to capture said value.

Even if for some reason you want the shares before expiry (and there is no divvie), and extrinsic value remains, it would still be better to sell the option and buy the stock in separate transactions... NOT exercise the option. Exercise only makes sense AT expiry, IF you want the shares ('cept for the divvie situation).

Click to expand...

Should have made this clear initially but I am talking about exercising the option when no extrinsic value remains. i.e On expiry.

Thanks for the quick reply though Wayne

Ok, so I have done some research and answered my own questions if anyone is interested.

You can exercise a put and hold a naked short postion on a security. This is exempt from s1020B(2) of the corporations act (Ban on short selling), link to ASIC Class order is http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/co08-764.pdf/$file/co08-764.pdf.

So you may exercise your put, and than place a buy order for the underlying securities.

WRT Delta, and exercising options vice trading them:
From Wikipedia:
"Delta, Δ, measures the rate of change of option value with respect to changes in the underlying asset's price. Delta is the first derivative of the value V of the derivative with respect to the underlying instrument's price S"

This means that when an option is ATM it's delta will be approximately .5. As the option moves OTM delta will gradually decrease, likewise as it moves ITM delta will gradually increase. If an option is ITM it's fair value will always be greater than underlying price - strike price (For a call) (Generally this plus extrinsic value). This can be seen by using an option price calculator, with 1 day until expiry (Minimal extrinsic value) the underlying, strike, fair value and delta of a call are shown below (Assuming typical values of volatility etc.)

Underlying / Strike / Fair value / Delta
100 / 100 / .527 / .506
101 / 100 / 1.178 / .781
102 / 100 / 2.048 / .937

And so on, assuming nothing out of the ordinary the fair value should always be greater than the inrinsic value of an ITM option.

So basically what this means is that as mentioned by many above you will usually be better off trading an option than exercising it.

Harro