When to Exercise Options
The question is frequent, but the answer is simple.
More than any other question, I get asked about when the owner of a call option should exercise that option. This is a very basic part of options trading, and it's mandatory to understand when and why an option owner would want exercise an option. Minyan Alex writes:
Dear Professor Wolfinger,
I'm a beginner. If I were writing an in-the-money covered call, would the strike price need to be reached before the buyer would call away the stock shares?
Thanks for your help.
When you write an in-the-money covered call, the strike price has already been reached. The stock's higher than the strike price. That's why it's called an in-the-money call option.
That fact is enough to tell you that seeing the stock reach the strike price is an insufficient reason for the call owner to exercise the option and "call away" the shares.
How do you know that? Because investors are willing to pay a price higher than the intrinsic value of the call option. No one in their right mind would pay a premium above intrinsic value and then throw away that premium by immediately exercising (the buyer may want to exercise weeks or months later, but not now).
Here's an example: You own shares of YZX, which is currently trading at $52 per share. You sell some YZX 50 call options (expiration date is immaterial) and collect $350 for each.
Note: These options are two points in the money. The stock is $2 higher than the strike price, and thus, the intrinsic value is $2 per share. The time premium (total premium minus intrinsic value) is $1.50 per share, or $150 per call.
Let's look at this from the perspective of the call buyer. They had these choices:
A. Buy stock, paying $52 per share.
B. Buy YZX call options with a strike price of 50, paying $3.50 per share. Hold the options until it's time to do something with them.
C. Buy YZX call options with a strike price of 50, paying $3.50 per share. Immediately exercise the option to take delivery of the shares.
Your question suggests there is a possibility that the call owner may want to select "C." If the owner exercises, it costs $50 per share to own stock. Add to that the $3.50 per share paid for the option, and the cost is $53.50 per share.
Why would anyone want to pay $53.50 (plus extra commissions) to buy stock that is available at $52?
Answer: No one would do that. It's possible, but unlikely, that it may be appropriate to exercise the calls at a later time. But that is a totally separate discussion and unrelated to your question.
It's important to understand why an investor will not exercise under the conditions you stated. If you can't understand why this is true, you are not ready to trade options. Don't make a single trade until you know why the buyer of a call option is not going to exercise when the stock reaches the strike price.
If the call owner blunders, it's possible to be assigned that exercise notice. Just don't expect it to happen in your lifetime. That's true no matter how high the stock moves. Any call owner who no longer wants to own those options should sell the options.
If the option owner were to exercise when the stock hits the strike price, that would be wrong. You never exercise an option when it has time premium remaining (that means any time it's trading at a price higher than the intrinsic value). There are other, very important reasons for not exercising, but you must understand this one before thinking about other reasons: You must grasp the basics before moving on.
If you meant to ask about an out-of-the-money covered call, the same principle holds true. The call owner will nave no reason to exercise any earlier than necessary (expiration), even when the stock rises and reaches the strike price.
The following is a very minor oversimplification and there are a couple of exceptions, but in general, you can take the following statement as gospel: It's almost always wrong for anyone to exercise a call option prior to expiration.
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