Options Trading: How to lock in unrealized gains?

Question

I've been learning about options trading, but the one thing I haven't explicitly read anywhere is how you actually lock in (i.e. cash out/collect earnings) from options trading.

Take the following example:

Company XYZ currently has a stock price of $50. I am bullish about company XYZ, so I purchase a single long call option contract with a contract price of $3.00 and a strike price of $55.

I pay $300 for the contract ($3.00 * 100 shares) and I have a breakeven point of $53.

Now some amazing news comes out about company XYZ and their stock skyrockets to $75. At this point I want to lock in my gains. Based off of everything I've read this far, to realize those gains I would have to do the following.

1. Exercise my right to buy 100 Shares of XYZ at $55/share
2. Once those 100 shares are issued to me, turn around and immediately sell those shares?

So my total profit would look something like this?

($55 * 100 shares) - $300 premium I paid for the contract = $5,200

Current value of XYZ stock: $75 * 100 = $7500

Total Profit: $2,300 (Excluding tax's and fees)

Are my assumptions correct, is that really the only way gains are realized or is there an alternative method to realizing gains?

Answer 1

You math is incorrect. You have subtracted the $3 cost of the call rather than adding it to your cost basis.

• -$3.00 cost of call
• -$55.00 cost of stock
• +$75.00 sale of stock
• ===============
• +$17 gain

When XYZ is $75, the $55 call has an intrinsic value of $20. If there is any time premium remaining then the bid price will be greater than $20 and you should sell the call to close on the option market to obtain the maximum return. Exercising an option that has remaining time premium throws money away.

Let's say that the bid is at the intrinsic value of $20. Sell it and given that your call's cost was $3, you have the same $17 profit as above.

What often happens with deep ITM calls closer to expiration is that they trade at a discount. When XYZ is $75, the quote for the $55 call might be $19.75 x $20.25. If you sell at the market, you'll take a 25 cent haircut.

You could place a STC order for a higher price than $19.75. Maybe another trader comes along and you get 5, 10, 15 cents of price improvement but there is really no incentive for the market maker or anyone else to give you the full $20. While waiting for a better fill, XYZ could drop in price and you could give back some of your $20 profit.

If you sell your call for $19.75, the market maker will immediately do a Discount Arbitrage. He'll exercise the call to buy 100 shares of XYZ at $55 and simultaneously sell 100 shares for $75, netting a 25 cent profit ( - $19.75 + $75.00 - $55.00).

If you have the funds in your account, you can do this Discount Arbitrage yourself, avoiding the haircut. If you exercise first, you'll have market risk and maybe you do better, maybe you do worse. Short the stock first to lock in the intrinsic value then exercise.

Answer 2

You may want to read upon the 4 Ways to Trade Options.

Assuming you bought an American-style call option, your maximum net asset value at Tp (present time), which is later than Tb (buy time), is the greater of the following:

1. Intrinsic value, which is what you described. If you exercise now, you buy the shares at $55 a piece and sell them higher, cashing in the profit.
2. Market value. You can sell to close the option position and pass the right, but not the obligation, to buy the underlying shares to another trader.

In the vast majority of the scenarios when Tp is before Te (expiration time), the market value is higher than the intrinsic value. Just look up the price for your option in either your broker's web interface or other data providers like optionsprofitcalculator.com.

Answer 3

When you bought the option in the first place, someone else was selling it. You can do the same thing, with a "sell to close" order where someone else will buy it from you, much like trading a stock.

Exercising before expiration is usually a worse way to close an option position, because it discards the option's time value.

There are a few mistakes in your scenario: The breakeven point is $58 ($55 strike + $3 premium), not $53. Your total cost for acquiring the 100 shares when you exercise is $5,800, not $5,200 (you should add, not subtract, the $300 option cost). So your gross profit is $1,700, not $2,300.

To round out the scenario, suppose when the stock hits $75, the option price is $20.50 because there is still some time value. Then you make an additional $50 profit by selling instead of exercising.