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I understand that when you purchase an option it is a contract that allows you buy or sell a security at a specified price on or by a certain time.

If you purchase a call option you have the right to purchase the security at the given strike price. So does that mean that you have to have the margin to actually purchase all of what you are allowed to buy as specified by the option and the immediately sell it to make a profit? Is there a market where you can sell a profitable option to those that wish to do the actual buy/sell transaction to make the profit off the option?

I'm just trying to work out a simple actual example of working with options that never seems to be included in any guides to working with them.

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Not all call options that have value at expiration, exercise by purchasing the security (or attempting to, with funds in your account). On ETNs, they often (always?) settle in cash. As an example of an option I'm currently looking at, AVSPY, it settles in cash (please confirm by reading the documentation on this set of options at http://www.nasdaqomxtrader.com/Micro.aspx?id=Alpha, but it is an example of this). There's nothing it can settle into (as you can't purchase the AVSPY index, only options on it). You may quickly look (wikipedia) at the difference between "American Style" options and "European Style" options, for more understanding here.

Interestingly I just spoke to my broker about this subject for a trade execution. Before I go into that, let me also quickly refer to Joe's answer: what you buy, you can sell. That's one of the jobs of a market maker, to provide liquidity in a market. So, when you buy a stock, you can sell it. When you buy an option, you can sell it. That's at any time before expiration (although how close you do it before the closing bell on expiration Friday/Saturday is your discretion). When a market maker lists an option price, they list a bid and an ask. If you are willing to sell at the bid price, they need to purchase it (generally speaking). That's why they put a spread between the bid and ask price, but that's another topic not related to your question -- just note the point of them buying at the bid price, and selling at the ask price -- that's what they're saying they'll do.

Now, one major difference with options vs. stocks is that options are contracts. So, therefore, we can note just as easily that YOU can sell the option on something (particularly if you own either the underlying, or an option deeper in the money). If you own the underlying instrument/stock, and you sell a CALL option on it, this is a strategy typically referred to as a covered call, considered a "risk reduction" strategy. You forfeit (potential) gains on the upside, for money you receive in selling the option.

The point of this discussion is, is simply: what one buys one can sell; what one sells one can buy -- that's how a "market" is supposed to work. And also, not to think that making money in options is buying first, then selling. It may be selling, and either buying back or ideally that option expiring worthless.

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Now, a final example. Let's say you buy a deep in the money call on a stock trading at $150, and you own the $100 calls. At expiration, these have a value of $50. But let's say, you don't have any money in your account, to take ownership of the underlying security (you have to come up with the additional $100 per share you are missing). In that case, need to call your broker and see how they handle it, and it will depend on the type of account you have (e.g. margin or not, IRA, etc). Generally speaking though, the "margin department" makes these decisions, and they look through folks that have options on things that have value, and are expiring, and whether they have the funds in their account to absorb the security they are going to need to own. Exchange-wise, options that have value at expiration, are exercised. But what if the person who has the option, doesn't have the funds to own the whole stock?

Well, ideally on Monday they'll buy all the shares with the options you have at the current price, and immediately liquidate the amount you can't afford to own, but they don't have to. I'm mentioning this detail so that it helps you see what's going or needs to go on with exchanges and brokerages and individuals, so you have a broader picture.

  • Yah, definitely. From talking to just my broker, a major thing here is how much value the option has. If it is deep in the money, there is a lot of value there, but if it is only worth 10 or 20 cents, then it's tougher. For example, on Saturday, the exchanges are closed. Who knows what the stock/etf/etn will open up at on Monday morning. So, one is best off making decisions before expiration, and not letting the brokerage decide for you, or telling them -- giving them instructions on how you want things handled in the cases where you don't act. – Ray K Jan 14 '12 at 13:50
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Today SPY (The S&P ETF) trades at $128.

The option to buy at $140 (this is a Jan '13 call) trades for $5.

I buy the call, for $500 as they trade in 100 lots.

The S&P skyrockets to 1500 and SPY to $150. The call trades for $11, as it still has a month or two before expiring, so I sell it, and get $1100. The S&P rose 17%, but I doubled my money. If it 'only' rose 9%, to less than $140, I'd lose my investment.

No, I don't need to buy the SPY I can sell the call any time before expiration. In fact, most options are not exercised, they are sold between purchase and expiration date.

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    So the idea seems similar to a 'Hot Potato' game. But I am assuming that eventually, once the expiration looms closer, that eventually someone is left holding the potato or will purchase to actually exercise the option? – Burton Samograd Jan 9 '12 at 18:32
  • @BurtonSamograd: Perhaps, but often the option contract is "closed out", that is, cancelled by the act of someone who earlier provided such an option contract ("wrote" it) who buys a contract. Since that person "owed" a contract, and now has acquired an equivalent one, the options clearing house cancels the contract and reduces the "open interest" count by one contract. – mgkrebbs Jan 9 '12 at 19:43
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    Burton, if it has any value at all, it will get exercised if the seller chooses not to buy it back. – JoeTaxpayer Jan 9 '12 at 20:00

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