3

As a follow up to my other question, I would like to know whether the following is possible:

  1. I have $20,000 in my brokerage account
  2. The price of the $300 call is $5.00 (1 contract = 100 shares)
  3. I buy 20 of the $300 calls (cost is $10,000)
  4. The price of the underlying goes up, making my option in-the-money

I decide to exercise my options.

Exercising my calls means that I have the right to buy 20*100 = 2,000 shares of the underlying. However, I only have $10,000 left in my brokerage account and therefore, I am unable to pay for the shares (2,000 * 300 = $600,000).

What now? How does this work in reality? Do brokers recognise that my position is profitable and buy and sell the underlying for me as soon as I exercise my calls?

In other words, do I need to worry about being able to pay for the shares of the underlying if I decide to exercise my options? Can I just take my profit without bothering with the shares at all?

  • 1
    Have you ever read something called "Option Value = Intrinsic Value + Time Value"? By excercising the option earlier than maturity, you immediately lose the Time Value portion of the current option price. – base64 Jun 12 '15 at 11:31
  • @base64: I have, and this post clarifies that it makes sense for deep-in-the-money options. Also, if I think the price of the asset will be lower at maturity then it is now, wouldn't it make sense to exercise? – Jean-Paul Jun 12 '15 at 12:02
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    Why do you think that the payoff you receive now by exercising is higher than the payoff you receive now by selling them to close the positions? I mean, its just two numbers. A > B then always prefer A. – base64 Jun 12 '15 at 12:06
  • @base64: I don't. I am trying to learn this stuff that's why I'm asking. What you suggest now is the exact topic of my other question (which I linked to in this question). So are you suggesting that I can simply trade options as leveraged products without bothering about the underlying shares? (mind you: I only have theoretical knowledge about options, no experience) – Jean-Paul Jun 12 '15 at 12:09
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    @base64: I have just edited my question to leave out the early-exercise part. I am still wondering what happens with in-the-money options at maturity if the person can't actually buy the shares (and margin being very high like the $600,000 from my example) – Jean-Paul Jun 12 '15 at 12:22
2

This is dependent on the broker according to The Options Industry Council.

Your broker will specify what they would do upon expiry (or hours before last trade) if you did not indicate your preference. Most likely they will conduct a probabilistic simulation to see whether exercising the contracts may result in margin deficit even after selling the delivered shares under extreme circumstances. In most cases, brokers tend to liquidate the option for you (sell to close) before expiry.

I've seen people complain about certain brokers forcing liquidation at terrible bid-ask spreads even though the options are still days to expiry. It is better for you to close the position on your own beforehand. The best brokers would allow margin deficit and let you deposit the required amount of money afterward.

Please consult your broker's materials. If you can't find them, use live chat or email tickets.

  • Perfect. Thank you. Just one detail: when selling to close, is there also a buying party? Surely someone must end up with the expired contracts? – Jean-Paul Jun 12 '15 at 13:01
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    Yes but the counterparty could just be buying to close their short call position. They could also exercise the option after buying it from you. They have plenty of money. – base64 Jun 12 '15 at 13:08
  • Understood. Now it's crystal clear to me, thanks :) – Jean-Paul Jun 12 '15 at 13:09
2

Unless you want to own the actual shares, you should simply sell the call option.By doing so you actual collect the profits (including any remaining time-value) of your position without ever needing to own the actual shares.

Please be aware that you do not need to wait until maturity of the call option to sell it. Also the longer you wait, more and more of the time value embedded in the option's price will disappear which means your "profit" will go down.

2

You may want to Sell part of the number of contracts ( say 18 out of 20) and use that proceed along with 10K that you have. So later 2 options will be exercised.

Also you said 200 * 300 = $600,000 and it should be 2000 * 300 = $600,000

1

It would be nice if the broker could be instructed to clear out the position for you, but in my experience the broker will simply give you the shares that you can't afford, then freeze your account because you are over your margin limit, and issue a margin call.

This happened to me recently because of a dumb mistake: options I paid $200 for and expected to expire worthless, ended up slightly ITM, so they were auto-exercised on Friday for about $20k, and my account was frozen (only able to close positions). By the next Monday, market news had shifted the stock against me and I had to sell it at a loss of $1200 to meet the margin call. This kind of thing is what gives option trading a reputation for danger: A supposedly max-$200-risk turned into a 6x greater loss. I see no reason to ever exercise, I always try to close my positions, but these things can happen.

  • In that scenario, isn't it possible to not exercise the contracts? Surely you have the privilege to decide on that, being you bought the contracts. – Jean-Paul Jul 8 '15 at 10:08
  • Yes, you can tell your broker not to exercise, that was the mistake - assuming they would expire OTM. – Dirigible Jul 8 '15 at 21:18
  • How do you tell your broker this? Is there an option for this in the software you use? – Jean-Paul Jul 8 '15 at 21:21
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    AFAIK you have to contact them directly. I know, so low tech. – Dirigible Jul 10 '15 at 1:46
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As other answers state, selling the options contracts to the market is a definite way out, and probably the best in most cases. If you're determined to exercise your options (or there's not enough liquidity to reasonably sell your contracts to the market), then you could plan ahead and exercise smaller number of contracts at a time and sell the resulting position in the underlying, which will give you funds to exercise some more contracts and sell the underlying. If you think you're going down this path, however, make sure that you take into account your broker's rules for settlement. You may need to start the exercise / sell cycle before the option's expiration date.

-1

Yes, this can be all resolved by placing a call to the broker and submitting a "Do Not Exercise" order. If it expires ITM and you don't want the shares then you just forfeit the premium paid for the contracts.

  • A Do Not Exercise order would only forfeit the current value of the option. If this was at expiry then the forfeit amount would be the intrinsic value of the ITM call. – Bob Baerker Oct 26 '18 at 17:17

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