A beginner question on call option

Question

I made my first options transaction. I believe that a stock that is currently trading around 25, will be in the 40s, come August - based on my research (I know the stock well, and I've invested in stocks for quite some time).

So: Current NYSE stock price $25. August 1st $27 Call, 10 contracts bought, at roughly 0.80 ($800 cost basis). This option is now trading at 1.50, as the stock has started to move upwards.. has a long way to go IMO.

My question relates to what I should do if my scenario comes true . Let's say in three weeks this stock goes to $35. So I'm in July beginning, options are going to expire in a month.

• Should I sell the call ? The Options strike price was 27, the stock is at 35. How it will work out if I do this. I've never sold a call before.

• I am bullish on this stock - so should I exercise these options - of course I'd need money to exercise 10 contracts (which is a 1000 shares, i.e. 27K).

I know things might not go per plan - but my question is more about if/when I need to exercise it, if this scenario happens (I am OK with losing initial investment of $800).

Answer 1

You've gotten some good advice answering your questions but not much in regard to managing your position.

You face two obstacles, time decay and share price reversal. Time decay is easy. Between now and August expiration, you are going to lose 80 cents per $27 contract unless share price moves up. On an expiration basis, share price must be $27.80 for you to break even. Break even will occur at a lower price than $27.80 if your stock's price has risen somewhat before expiration.

Some option info before proceeding. Delta is the amount that an option will rise or fall per dollar change in the underlying. An at-the-money option has a delta of about 0.50 and as a call rises, its delta will rise. If your stock is $35 in early July, your call's delta will be close to 1.00 which means that your call will be acting like the stock. For every dollar the stock rises, your call will rise a dollar. At this point, you will have significant risk (loss of profits).

At $35, there will be no time premium remaining in the call and you will have lost the 80 cents of time premium. However, the call will be trading for intrinsic value which is $8 ($35 - $27) so your gain will be $7.20 per call. That's the risk. What to do?

If $7.20 is acceptable, simply sell the calls to close (B/A and fewer commissions). The only reason to exercise the call is because

1. You want to own the stock

2. The bid price is trading below parity (less than intrinsic value) and you don't want to take the haircut for STC (I'll explain this later if you want). Obviously, you would need the cash (or margin) to support this trade.

Reaching $35 in early July is short of your target price in the 40's by August expiration. If you want to participate in further upside movement, you have to make some decisions. You could just ride the existing position, risking the $7.20 profit per contract. Or you could use some more sophisticated option strategies to pull some money off the table. I'll just mention two of the possibilities.

1. Convert the position to a strangle. Spend another 80 cents (price guess) to buy the August 33 put. The most you could give back if the stock dropped would be $2.80 (the cost of the put plus the drop to the put's $33 strike). What does this mean? You would be guaranteed a profit of $4.40 between $27 and $33 and that $4.40 profit would increase one dollar for every dollar your stock was above $33 or below $27. So for example, at $40, your call position would have a $11.40 gain ($40 - $27c - $0.80 - $0.80), only 80 cents less than had you done nothing. If the stock collapsed to $20, you would also have a profit of $11.40 because of the put ($33p - $20 - $0.80 - $0.80). Risk and reward go hand in hand so if you want a better result on one side, you have to give up something on the other side.

2. Roll the Aug $27 calls up to cheaper calls at a higher strike price of the same or later expiration. This pulls money out of the position, booking gains. The trade off is that you will now have a lower delta and your position will no longer track the underlying $1 for $1. Suppose you sold the $Aug 27 call for $8 - booking the $7.20 profit and duplicated your original position by buying the Sep $37 call for 80 cents. The delta of the Sep $37 call would be 35, similar to your original position. You've eliminated the risk of losing a terrific profit but in return, you have also lowered your potential profit going forward. Trade offs.

This may sound a bit daunting but if you are going to trade options, you should also learn about money management as well. You have to decide if you want to take the win, continue to risk it all, or lock in some gains while cutting risk and diminishing the total profit potential somewhat.

Answer 2

Should I sell the call ?

Your current downside risk is if the stock begins to fall, the value of your options will fall as well. There's no risk of you losing any more cash since you already paid for the options and they can't go below zero.

You could lock in your gains by selling the call. The risk at that point is that you miss out on any gains based on the underlying stock rising. If you want to limit your loss from here, you could put in a stop-loss sell order at some point (note that your stop point will be the price of the option that you want to sell at, not the price of the underlying stock).

How it will work out if I do this. I've never sold a call before.

You would place a "sell to close" order. The simplest is to place a market order (just sell at whatever price you can sell for immediately), or a limit order (sell at price X or higher), which might get you more, but might not get filled at all if the price doesn't reach X. You sell the call to someone else (it doesn't matter who - the exchange takes care of this for you), you get the premium you sold the option for in cash, and you no longer have any position on the option. Any profit or loss from the difference in premium is locked in.

The alternative is, of course, is to ride the call to expiry and decide at that time whether you still think the stock has room to grow or whether you want to sell the stock.

of course I'd need money to exercise 10 contracts

If you don't have the cash to exercise (and/or don't want to buy the underlying stock), then the next best option is to sell the option to close your position on the day that the option matures. The difference in value between the option and the profit you'd get from exercising and selling the stock is minimal at that point, and should be slightly in your favor.

my question is more about if/when I need to exercise it

Very rarely is it worth exercising an option early. You will get more by selling the option than you will by exercising it and selling the stock for a profit.

Answer 3

The way option traders make a lot of money is by flipping their contracts. It takes courage, and one can easily lose all the initial "investment" at anytime. Investment is in quotes because maximizing profit in the manner I am about to describe is speculation, not investment.

Lets assume that you KNOW that a stock will rise $1 per day for the next 30 trading sessions. So it will go from $25 to $55. Also assume that no one else knows this but you. Lets also assume that you know the bump will happen between 11 and 2. And that you have $1,000 to start with.

On the first day you would buy the maximum number of contracts that you could with your 1,000. You would aim for slightly out of the money contract (less than $.50) with short expiration dates. Those options are pretty much worthless, so you could get a lot of them for your $100. Then the bump happens. Your out of the money options are now in the money and have a real tangible value. You probably made 3-10x on your money, so you will be left with at least 3k or so. You sell them.

Each morning you could repeat this pattern. One could turn that 1,000 into 6.5 million in 9 trading sessions, always rolling the maximum amount.

While those kinds of numbers are impractical they were possible when things like the Enron crash occurred. Many people are betting exactly that on Tesla, however, they keep losing large sums of money.

- OR -

You can also make a very conservative bet, that could yield a healthy return. Buy leaps. You could buy a 1 or 2 year leap, with a strike of 40, for a small amount. This way if August comes and goes, and there is no bump in price you could hold them for longer; or, sell them at a small loss.

If there is a smaller than expected bump, you could still profit.

If there is a large bump, you will likely make in the 3x or 4x range for a relatively small change in stock price.

The plus side is that, you could participate in a much larger growth, with leaps, than if you had just bought the stock. And you also have significant downside protection.

Answer 4

Before your options expire, if you think the stock will keep rising, you can:

• Sell all the options and buy new ones, to continue (high risk!) in a leveraged position on these stocks.
• Sell enough options to finance exercising the rest of the stock options. This way you continue bullish on the stocks, but with less leverage (and therefore also less risk).

Otherwise, if you don't think the stock will keep rising at the point of expiry of your options, just sell the options. I wouldn't recommend exercising the options yourself just to sell the stock immediately, there is probably too much overhead involved.