Options basics: How to realize profit from a long call position

Question

I'm studying the basics of options trading and just read a 'crash course' book where the author states the following:

...you won't walk away from a call option with cash in hand. The profit we are talking about in this case is "intrinsic value". You can now take that stock and write a buy contract on it, selling it on and making that tangible profit in the process. ... as an options trader, you're not looking to keep hold of a stock portfolio. You're purchasing stocks through contracts to turn around and sell for a profit.

So I have a fundamental question about long call options. Is the author here alluding to a requisite purchase of the underlying shares before a "buy contract" can be written against them? Surely, this is implied, because without executing the contract, you would have nothing to sell, right?

My confusion is compounded by a statements just a couple of paragraphs prior

Buying calls also allows you to consider shares that would ordinarily be out of your price range. ... Buying options on those stocks is a whole lot less expensive than buying the stocks themselves, ... This is call "leverage": the ability to control thousands of dollars in stock for just hundreds of dollars in premium.

Here again I'm lost - if you have to execute the position in order to profit, then you need the full amount of the contract to ultimately purchase those shares, right?

Lastly, if I have a long call that becomes valuable, whereby the strike price + premium is less than the current price of the stock, I then need to execute the option, buy buying the stock, before I can actually sell those shares (immediately after purchase) for a profit, right? Or is there some other way to realize the profit without actually purchasing the stock?

Answer 1

It's no wonder that you're confused. The first paragraph that you quoted is a disaster. In clearer words:

• If a call appreciates in price and you sell it, you walk away with cash in hand and a profit

• That profit can be from intrinsic or extrinsic premium (the call's price must simply appreciate)

• There is no such thing as writing a buy contract. Writing is synonymous with selling to open (STO). If you were to sell a call against the original long call, you would be creating a spread (vertical, calendar, diagonal).

There are two reasons to exercise an ITM call:

1) You want to own the stock.

2) If a call is ITM and it trades for less than parity (bid is less than intrinsic value) or as you wrote, the "strike price + premium is less than the current price of the stock", you can try for some price improvement with your STC order but there is no incentive for the market maker or anyone else to give you the full intrinsic value. While waiting for a better fill, the price of XYZ could drop and you could give back some of your call's gain.

To avoid this haircut, you can perform perform the same Discount Arbitrage that a market maker would. If you have the margin to cover a short sell, short the stock and then exercise the call. That locks in the intrinsic value and avoids the haircut (short the stock first to avoid possible underlying price slippage). If you don't have the margin then you're going to have to work the order and take whatever you can get. If you need an example, ask away.