Why Option Owners Shouldn't Exercise
You have the right to, but more importantly, you have the right NOT to.
Minyan Scott writes:
I've read that it's possible to be right about the direction of the stock and the timing and still lose money at expiration. Can you give me an example? My understanding is that I could exercise the call option or sell the option for a profit.
Here's an example: Apple (AAPL) is $205. Believing the stock will move higher, you buy the Nov. 210 call, paying $4.
You're correct: When expiration arrives, Apple has rallied to 209. Your option expires worthless, and you lose $400.
Perhaps you're even more correct. The stock slowly rises to 213 and closes at that price on expiration Friday. Your option is worth $300 and you paid $400. A $100 loss.
If it's your understanding that you can always earn a profit, forget it. When you buy options, you'll lose money far more often than half the time. The goal is to have enough large gains to offset the frequent losses.
I have a question for you: Why are you mentioning the idea that you "could exercise" the option? Did you "learn" that exercising is a reasonable choice?
Addendum: Any time that the option is trading at a price that's higher than the price you paid, you can sell the option for a profit. In this respect, trading options is exactly like trading stock.
Minyan Scott continues:
If I'm correct about the direction and timing of a stock and the option/stock is out-of-the-money by several points, I could exercise the option, sell the stock, and keep the profits. Do I have to have sufficient funds in my account while the option is active in order to buy it at the strike price? Hypothetically, I could control $2,500 of stock for $500 worth of options. Does this mean I have to set aside $3,000 ($500 for the premium and $2500 in case the stock reaches the strike price) until exercise or expiration?
This question frightens me to the core and I hope you haven't yet begun trading options with real money.
1. If you own a call option that's out of the money, it means that the stock is trading below the strike price.
Under those conditions, no one in his/her right mind would exercise an option. Look at it this way: You own Google (GOOG) Nov. 560 calls and the stock is $557. You have a choice: You can buy shares at $557 in the open market, or you can exercise your right to pay $560.
Which do you think is a better idea? $557 is the only reasonable answer.
When you own an option, you have the "right" to exercise. But more importantly, you have the right not to exercise.
Let me assure you that an option owner should almost never exercise. Yes -- there are exceptions -- but for someone who's speculating by buying options as you're doing, just forget about exercising and sell the option when you no longer want to own it.
One more point: The stock is never in or out of the money. Those terms apply only to the option.
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