Why hold calls until expiration?

Question

I am reading a book on options basics. I am in a chapter on selling covered calls. The author says that buyers of calls almost always hold the calls until expiration.

Why is this? Here's how I imagine buying calls: I buy a call at a strike price of $50. The call expires in 2 months. In 2 weeks, the price of the stock goes up to $60. Because I don't know whether it will go back down below $50 between now and when my option expires, I exercise the option now and make a profit.

What am I missing? Why would I hold a call option until expiration?

Answer 1

The author is wrong in saying that buyers of calls almost always hold the calls until expiration. According to stats provided by the CBOE for 2017:

1) About 10% of options were exercised (gain or loss)

2) About 60% were closed before expiration

3) About 30% expired worthless

In your scenario, if you bought $50 calls and two weeks later the stock rose to $60, if there is any time premium remaining then it would make more sense to sell the calls to close rather than to exercise them. This saves B/A slippage and incurs fewer commissions.

The only time that it makes sense to exercise the call and sell the stock is when the call is deep in-the-money (as your is), the bid is less than intrinsic value and your commission total is less than the haircut you'll take for selling your call below fair value. And while it may be a bit esoteric, if one has the approval and the margin to do so, short the stock and then exercise in order to avoid slippage (not a cash account).

EDIT: An example to clarify Lawrence's question in the comments:

LRCX is trading at $175.25 and the Aug 17th $160 call is $14.70 x $16.20 with an intrinsic value of $15.25

If you sell the call at the market, you'll take a 55 cent haircut. You can put in an order to sell for closer to fair value and you're likely to get some price improvement but you won't get $15.25 .

If you exercise the call, you'll buy the stock at $160 and you can immediately sell the stock for $175.25, nabbing your $15.25 (less two commissions if you broker charges for assignment and exercise). Haircut avoided.

In reality, if you set up your sell order before exercising, there's still a few seconds of market risk between transactions. If LRCX drops, you'll net less than $15.25 . The odds are slim but 'shift' happens on my keyboard so why tempt fate?

The exercise price is constant regardless of the moment to moment fluctuation in the price of LRCX so if you short the stock at $175.25 and then exercise, you're guaranteed your $15.25 . No shift, no fate.

Answer 2

In 2 weeks, the price of the stock goes up to $60. Because I don't know whether it will go back down below $50 between now and when my option expires, I exercise the option now and make a profit.

What am I missing? Why would I hold a call option until expiration?

First, what do you do if the price goes to $40 instead of $60? You hold. If you hold long enough, the options expire. If your assumption is "at some point during the 2 months the stock will be worth more than it is now", then it would hold that just buying a given stock and selling it in the future is a guaranteed profit -- but you know that this is not the case.

Second, the chance that the price will go up is priced into the cost of the calls. If it is the general assumption that the price will go up, the calls will be more expensive to compensate, requiring the price to go up higher before you are turning a profit. After all, those people who are selling the calls may be hedging rather than trying to profit, but they will still be selling for as much as people will pay.

Third, it is a matter of amount of profit. If you have two month options, and the price goes from $50 to $52 on day one, do you sell to lock in that profit, or hold for more profit? The former is safer, but you'll be eating into your profits via the call costs.