I've never used options before, but I would like to give it a try. The first thing I want to do is understand as much about call options before moving on to the more difficult, in my opinion, put options.

What I understand so far is that you can buy a call option which give you the "option" to buy 100 shares at a specific price. As the share price moves, the option price moves too.

As an example, let's say I buy one call option of ABC for $1 at a strike price of $100. Its expiration is in 30 days and the price is currently hovering at $90. Let's also say that 2 days before the expiration the stock is at $105. How can I profit from this with minimal risk? I think my options are:

  • Sell the option. If I use this method and the stock continues to rise, won't I be on the hook to buy the stock and give it to the option buyer? In theory it could negate my profit from selling the option.
  • Buy the stock, then immediately sell it. This means I would need the money available for 100 shares and would require me to try to sell them quickly. It's possible I won't have the funds for 100 shares of the stock.

If my understanding of options is incorrect, please assist me.

How can I profit from this with minimal risk?

First, note that your risk is limited to how much you paid for the option. Either you'll buy the stock at a lower price and profit, or the stock will be below the strike and nothing will happen. So it really comes down to how to maximize profit when closing an option you've purchased.

An option is almost always worth more than the "intrinsic" value, meaning the difference between the strike and the underlying stock price ($5 in your example). Selling the option to close is almost always the most profitable course. Options have excess value to account both for the risk that the price will drop below the strike and the time value of money, so finding a call that's selling below it's intrinsic value is very, very rare.

Sell the option. If I use this method and the stock continues to rise, won't I be on the hook to buy the stock and give it to the option buyer?

No. Whoever is on the other end of your original option contract (you won't know who that is) is still on the hook to provide the stock. If you "sell to close" your option position, you are out of the deal have no risk whatsoever.

You could also think of it this way. Suppose you sold a new call option to someone else (meaning you still had the one you originally bought and the one you just sold). You would 1) buy the option from the original counterparty for $100 then sell it to the new counterparty for $100, for a new wash. In reality, though, the option is "transferred" to the new buyer.

Buy the stock, then immediately sell it.

Yes, you will profit $4 per share assuming the bid price is $105 ($5 from the stock less the $1 you [paid for the option), but as you said, you will need the cash to buy the underlying stock first. Plus, as mentioned above, selling the option is generally more profitable. You might also have some price risk if, say, the bid price drops between the time you exercise the option and the time you place the sell order.

  • Small details... ITM options near expiration are often worth less (what you can sell them for) than intrinsic value. Intrinsic is $5 but profit is $4 in OP's example. Exercise of call and sale of shares should be done simultaneously so there is no time/price risk. If there is a lag in execution confirmation then it's not a good broker for this. – Bob Baerker Jul 6 at 16:43
  • "you will need the cash to buy the underlying stock first." Can you really not do a cashless exercise-and-sell like you can with ISOs? – Kevin Aug 5 at 17:54
  • @D Stanley - "You might also have some price risk if, say, the bid price drops between the time you exercise the option and the time you place the sell order." The purchase price does not change because that is the right that one has because one owns the call (the strike price). There would be no price risk if one sold the shares short and then immediately exercised the call. Lock in the fluctuating side and then exercise the fixed side. For this exit, margin account required. – Bob Baerker Aug 10 at 19:08

For the most part, puts are the mirror image of calls and they really aren't more difficult than calls. It's just a matter of getting used to thinking in the opposite direction (up versus down).

A call's price may or may not move up as share price increases. There are other variables in play that determine option premium and they may offset minor increases in share price if/as they act in opposition (time decay, decrease in implied volatility, pending dividends).

In your example, as the owner of a call, you have the right but not the obligation to buy 100 shares at $100 anytime before expiration. If you do nothing, the OCC will automatically exercise it if it is one cent is in-the-money at expiration and you will have to buy the shares ("Exercise By Exception"). So if you do not want that to occur, you must STC (sell to close) before expiry.

With the stock at $105 two days before expiration, your one month call will have an intrinsic value of $5 ($105 - $100). If you sell it to close, you'll realize a $4 profit and you are done. Whatever happens to share price after that is of no concern to.

Your explanation of this isn't clear. You mentioned buying the stock and then immediately selling it. If that refers to exercising the call to acquire the stock and then selling it then yes, you could do that but it makes no sense to do so if you can sell the call for its intrinsic value because that incurs less frictional cost. If the bid is less than intrinsic value then there's another possibility - read my previous post here:

Options and exercise

I'd suggest that you pick up an older edition of "Options as a Strategic Investment" by Lawrence G. McMillan and spend a few months with it. Read it and then read it again. I recommend an older edition because you can pick one up copy for $5 - $10. There's no need to spend $75+ for the latest edition (1,000+ pages) since it involves more complex products and strategies which will most likely not be of interest to you for some time, if ever.

In the end, you need to understand the inter-relationship between various option strategies as well as to the underlying and apply that information to your investment/trading plan. It's no easy task. Take your time and determine if options might facilitate achieving your goals.

  • (1) Is it not "buy 100 shares at $100 anytime before expiration"? (2) Regarding "but it makes no sense to do so [exercise + resell] if you can sell the call for its intrinsic value" surely, to realise the "intrinsic value", someone will have to exercise the option before it expires? It can't just keep being resold as the expiration date approaches, otherwise there's a danger the option will expire and no value will have been realised... or am I missing something? – TripeHound Aug 6 at 8:18
  • Sorry, but I don't follow what you are asking in (1). Regarding (2), if you own an ITM call and it has any time premium remaining, you throw that away by exercising it and then you have add'l commissions for buying and then selling the underlying ("makes no sense exercise + resell"). Just STC the call. If the buyer is doing a BTC then the call disappears from existence and the Open Interest drops by 1. If the bid is trading below parity (less than intrinsic value then it makes sense to exercise and sell in order to avoid the haircut. If you want an example, ask away. – Bob Baerker Aug 10 at 1:59
  • In the US, ITM options don't expire worthless. The OCC automatically exercise all options that expire one cent ITM (Exercise By Exception). Option owners can avoid this if they designate to their broker that this should not occur.. – Bob Baerker Aug 10 at 2:01
  • Thanks. I didn't appreciate the "automatically exercising" aspect. So, in a sense (unless they explicitly chose not to) the last holder does exercise the option, it's just that it's triggered by the OCC automatically? Re. (1) I think it's just a typo: the beginning of your 3rd paragraph says "right but not the obligation to buy 100 shares at $90"... but the strike price in the question is $100; the $90 is, I believe, the current price of the stock. – TripeHound Aug 10 at 6:44
  • You're right, it was a typo. Sorry for the confusion and thanks for catching that. Poof! It's edited and gone. – Bob Baerker Aug 10 at 12:06

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