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I'm a little confused on how this article comes up with $650 instead of $700.

From Investopedia.

Consider the following example:

XYZ is currently trading at $99.00
You own one XYZ Oct 90 call option
The XYZ Oct 90 call option is priced at $9.50
October expiration arrives in two weeks

1) Increased Risk Exercising this call option prior to expiration increases risk. More importantly, you gain nothing by taking on added risk.

When you own the call option, the most you can lose is the value of the option, or $950. If the stock rallies, you still own the right to pay $90 per share. It is not necessary to own the shares to profit from a price increase and you lose nothing by continuing to hold the call option. If you decide you want to own the shares (instead of the call option) and exercise, you effectively sell your option at zero and buy stock at $90 per share.

Let's assume one week passes and the company makes an unexpected announcement. The market does not like the news and the stock opens for trading at $85 and sinks to $83. That's unfortunate. If you own the call option, it has become almost worthless and your account has dropped by $950. However, if you exercised the option and own stock, your account value has decreased by $1,600, or the difference between $9,900 and $8,300. This is an unacceptable loss because there was never a chance to gain by exercising the call option and, although you were unlucky, you lost an additional $650.

Exercising the call option at $90 a share for 100 shares would cost me $9,000. If the stock is at $8,300 it means that I'm down $700

How did Investopedia come up with $650? Am I missing something?

  • can it be that you spent some money to buy the option? The XYZ Oct 90 call option is priced at $9.50 – aaaaaa Apr 23 at 21:54
  • You can use the > symbol to indicate a quote. – Acccumulation Apr 23 at 22:04
  • Thanks for the link. Having now read the article, another problem is that the author worded his statement poorly and we assumed that he meant exercising at $83. "However, if you exercised the option and own stock, your account value has decreased by $1,600." It should have read: "However, if you exercised the option before the stock's drop and you owned stock, your account value has decreased by $1,600." That would still be wrong since he ignored the $50 of time premium. The total loss would be $1,650 not $1,600. – Bob Baerker Apr 23 at 22:13
  • @JohnAdams - Welcome to Money.SE. Investopedia is riddled with errors and authors rarely re-visit an older article to correct. The one time I tried to have an author correct a "Roth Conversion" article, the author simply replied that he felt he was correct. Other correction emails went unreplied. I never cite them as a source. – JoeTaxpayer Apr 24 at 2:35
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This is an example of "Not everything that you read on Investopedia is correct".

No one in their right mind would exercise a call to buy an $83 stock for $90. I suspect that most broker software would prevent this.

To your question, the author's math is wrong and yours is correct. If one could exercise and buy $83 stock for $90 (per the author), one would lose $700 on top of the $950 cost of the call for a net loss of $1,650. This assumes that the call expires worthless (there would be salvage value at $83 one week before expiration).

There are some other subtle problematic issues in the article but I'll leave it at that.

  • What is incorrect about the article? – Acccumulation Apr 23 at 22:19
  • For starters, there's the bad math. After the drop to $83, the $90 call would not be almost worthless (with no IV bump). There's the assumption that exercising forces the account holder to use margin. Going on margin is elective. Exercising the call to capture a large dividend is not a good idea (taxes if non sheltered and there's no dividend arb available for calls though under certain circumstances, there may be one for ITM puts). – Bob Baerker Apr 23 at 22:34
  • @BobBaerker My reading is that you exercised the option when the price was $99, then – a week later – you wake up to find that the $99-stock you bought at $90 opened at $85 and immediately dropped to $83. The second half of the last paragraph would, I think, be better as "However, if you had already exercised the option and now own stock". – TripeHound Apr 24 at 8:05
  • @TripeHound - I suggested the same correction in a comment to one of the other answers. Among other reasons, the article is poorly written if some are interpreting it is exercise before the drop and others as after the drop. – Bob Baerker Apr 24 at 12:17
  • "After the drop to $83, the $90 call would not be almost worthless" Investopedia says it is, and they're the ones creating the hypothetical. "There's the assumption that exercising forces the account holder to use margin." What does that mean? "Exercising the call to capture a large dividend is not a good idea" I didn't see anything about dividends. – Acccumulation Apr 24 at 14:55
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If you own the call option, it has become almost worthless and your account has dropped by $950.
...
However, if you exercised the option and own stock, your account value has decreased by $1,600, or the difference between $9,900 and $8,300. This is an unacceptable loss because there was never a chance to gain by exercising the call option and, although you were unlucky, you lost an additional $650.

If you own the option, you lose $950. If you own the stock, you lose $1600. $1600 minus $950 is $650.

  • If you own the stock, you lose $1650 total. Don't forget, the $50 time premium you paid. – JoeTaxpayer Apr 24 at 0:21
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I believe the Investopedia math is wrong -- it should say "you lost an additional $700".

The "you lost an additional $xxx" phrasing comes from the difference between how much you lose if you take Approach A and how much you lose if you take Approach B.

Approach A -- Buy the options; let them expire worthless.

You buy 100 options at $9.50. That costs you $950. You let them expire worthless, so you lose the entire $950.

Approach B -- Buy the options; exercise the option to buy the stock; sell the stock.

You buy 100 options at $9.50. That costs you $950. You exercise them, buying 100 shares of XYZ at $90 for a cost of $9000. Then when the stock drops, you sell the stock at $83, for income of $8300. $8300 - $950 - $9000 = a loss of $1650.

Thus, Approach B costs you $700 more than Approach A does.

The point of the article still stands -- early exercise of this option contract increased your downside risk, but did nothing to increase your potential gain.

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