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.
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