Q&A
Explore Your Options
| Got a question about options? Tom Gentile
is the chief options strategist at Optionetics (www.optionetics.com), an
education and publishing firm dedicated to teaching investors how to minimize
their risk while maximizing profits using options. To submit a question,
post it on the STOCKS & COMMODITIES website Message-Boards.
Answers will be posted there, and selected questions will appear in future
issues of S&C. |
Tom Gentile of Optionetics |
RISK OF BUYING CALLS
I've recently watched the behavior of call options of some growth
stocks during their rallies, and the profit potential looks phenomenal.
How dangerous is it to buy naked calls at the beginning of the rally and
sell them at the top when the calls are deep-in-the-money? How often do
in-the-money (ITM) options get exercised?
An option is a standardized contract or agreement between two parties,
a buyer and a seller. A put option buyer has the right to sell or put a
stock at a specific price, known as the strike price, until that option
expires. The buyer of a call option has the same right to buy or call a
stock. Each stock option contract gives the right to buy or sell 100 shares
of stock. Option buyers pay a premium for the right to buy or sell the
underlying stock.
Options sellers have an obligation to fulfill the terms of the contract.
They receive option premiums in exchange for this obligation. A put seller
has the obligation to buy or have the stock "put" to their trading account.
A call seller, or writer, is taking on the obligation to sell the shares
at a specific price.
Buyers of options have the right but not the obligation to exercise
their options. As a call buyer or owner, I want to see the price of the
underlying stock move higher because that will make my options contract
more valuable. If my call option has a strike price of 50 and the stock
prices rises from $50 to $60, my options will increase in value. At $60
a share, my call with a 50 strike price is now deep in-the-money because
the stock price ($60) is well above the strike price (50) of the call option.
At that point, I can call the stock from the option seller for $50 and
sell it in the market at $60 a share. The result is a $10 profit per share,
minus the cost of buying the call option.
So it is true buying calls on growth stocks can provide phenomenal profit
potential if the stock makes a big move higher. However, the call buyer
never has to worry about getting exercised. It is the call buyer's decision
whether the call is exercised. If the stock makes a large move higher,
the call owner might choose to exercise that option and buy the stock at
the strike price of the contract. However, the call holder is not obligated
to do so. The call option, which has probably appreciated along with the
stock, can be sold for a profit.
Thus, it is the option owner's decision if and when an option is exercised
and not all ITM contracts are exercised. Some are sold for a profit instead.
The maximum risk to buying a call is the cost of the options contract,
or the premium.
WHEN AUTO-EXERCISE IS A FACTOR
I read that options are sometimes automatically exercised at expiration.
When do I need to be concerned about being subject to auto-exercise?
The Options Clearing Corp. (OCC) has set guidelines concerning the automatic
exercise of options at expiration. The OCC is the organization that oversees
the options market. It works with options exchanges, brokers, and market
makers to set policy. The OCC plays the important role of guaranteeing
the integrity of the option markets.
Beginning with the October 2006 options expiration, the OCC implemented
a new rule that stated all options that are a nickel or more in-the-money
(ITM) at expiration will be automatically exercised. Previously, the threshold
was $0.25. The new rule means any holder of options that are ITM will have
that option exercised.
Here's an example. I hold XYZ 50 calls heading into December 2006 option
expiration. The stock is trading near $49.50 in the second week in December.
On December 15, the last day of trading for the options contract, it rallies
up to $50.05 a share. The next day, the contract will be subject to automatic
exercise because the call option is five cents in-the-money. So 100 shares
of stock will be purchased for $50 a share for every call contract. If
the stock stays at $50.05 on Monday morning, it can be sold for that amount
and the trader will pocket a nickel a share profit from the trade (minus
the cost of the call option).
Auto-exercise is designed to protect investors and make sure they don't
inadvertently leave money on the table. Sometimes, however, the strategist
will not want options exercised, even if he or she is slightly in-the-money.
In that case, strategists should contact their brokers and instruct them
not to exercise the options at expiration.
ASSIGNMENT VS EXERCISE
I have heard the terms "assignment" and "exercise" used in reference
to options. What is the difference?
An option buyer can choose to exercise an options contract. If so, an
option seller will face assignment. Exercise refers to the option owner's
action with respect to the contract. If it is a call, the owner will exercise
their right to buy the shares at a specific price. With a put, the option
owner will exercise their right to sell the underlying asset at a specific
price. Assignment is what the seller must honor if the contract is exercised.
If assigned on a call, the option seller will be forced to sell the underlying
asset based on the terms of the contract. In the case of a put, the option
writer faced with assignment will be asked to buy the underlying asset
in accordance to the terms of the options contract.
Originally published in the December 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
Return to December 2006 Contents
Find us on Facebook
