How you lose exercising options early

There has been the odd question about exercising options early, eg https://www.aussiestockforums.com/forums/showpost.php?p=242518&postcount=26

My answers may have not been very clear so thought I'd tidy it up a bit with an example to show how you can lose. This example will be with ETOs, but equally applies to company options. (For ease of calcs, no commish or expenses will be considered)

Lets say you own a contract (100) of EBAY Jan 2009 $20 call options. The value of that option right now is 11.60 with EBAY shares trading at 29.80. You have $5000 in your brokers account

That means you have an assets valued at $6,160 i.e. cash of $5k plus options valued at $1,160(what you paid for them is irrelevant for this example)

They're nicely in the money and you want to own the shares so you ring up your broker and ask him to exercise.

The next morning you check your brokers account and (presuming the shares are still trading at $29.80) you now have 100 EBAY shares valued at $2,980 and cash at $3,000, total assets of $5,980.

Hang on! $180 has disappeared somewhere. Where did it go?

Re: How you lose exercising early

The answer is that you have thrown away the extrinsic value of the option.

It was a $20 option worth $11.60 with EBAY trading at $29.80. That means it was $9.80 in the money, leaving an extrinsic value (time value) of $1.80. $1.80 x 100 is $180 and voila! There's the missing money. When you exercise any option with time value remaining, you forfeit that time value.

What to to in this situation (you want to own the shares)?

You need to capture the extrinsic value of the option by selling it.

So you sell the option at market value and pay market value for the shares.

We'll realize $1.160 for the options to go into cash, pay $2,980 for the shares and be left with $3,180 cash in our brokers account.

Same result, we have our 100 EBAY shares, but we're still worth $6,160 by capturing the extrinsic value of the options.

Bon Marche

Re: How you lose exercising early

Good posts wayneL - question if I may. You refer to extrinsic value as the value other than the intrinsic value. I have always referred to extrinsic value as "time value" - any thoughts on this or are the two terms interchangeable?

Re: How you lose exercising early

Timmy said:

Good posts wayneL - question if I may. You refer to extrinsic value as the value other than the intrinsic value. I have always referred to extrinsic value as "time value" - any thoughts on this or are the two terms interchangeable?

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The terms are interchangeable.

But I prefer "extrinsic" because the extrinsic value also includes value accounting for volatility. Just my preference and doesn't really matter as long as we all understand each other.

Cheers

Re: How you lose exercising early

wayneL said:

extrinsic value also includes value accounting for volatility

Click to expand...

"Extrinsic value" would seem more precise, will update my vocabulary!

Re: How you lose exercising early

I read the thread last night but reading the thread at this time of the morning I was thinking is this about physical exercise and early mornings.


Hmm I think I need some sleep :

Re: How you lose exercising early

bvbfan said:

I read the thread last night but reading the thread at this time of the morning I was thinking is this about physical exercise and early mornings.


Hmm I think I need some sleep :

Click to expand...

stop grizzling - you only read that - I've just come back from a 10km jog before breakfast to find this out also

Re: How you lose exercising early

Ahahaha!

That was a bit vague of me wasn't it.