Series 7

AAA

Derivatives - When To Exercise An Option

Because the options being discussed here are listed - that is, exchange-traded - options, the secondary market is also a factor. The person who holds the option at the expiration date is generally not the same one who bought it when it was first written. Options lose value over time. Like dairy products, the closer options get to their expiration date, the less they are worth.

For the options holder, the real trick is determining when to exercise an option and when to let it expire. The decision hinges on the concept of intrinsic value or, to use the prevalent term on the Street, "moneyness".

  • An option is in-the-money if it has positive intrinsic value - that is, if the holder would profit from exercising it.
    • In terms of strike price, a call is in-the-money if the exercise price is below the underlying stock's spot price;

    • a put is in-the-money if the exercise price is above the stock's spot price.

  • Conversely, an option is out-of-the-money if the holder would lose money by exercising it. If you recall, this section on derivative products started with an example in which an option holder had the right to buy a stock at $25 and the share price went up to $40. If the stock had stayed in the low-$20s doldrums it was trading at when the opening transaction occurred, the option would have remained out-of-the-money, the writer would have collected a premium, and the contract certainly would have expired unexercised.

    • An option that is out of the money has no intrinsic value. An in-the-money option's intrinsic value is the difference between its strike price and its spot price.

  • It is conceivable for an option to be at-the-money - sometimes called being at parity - but being at-the-money is effectively the same as being out-of-the-money.

    • If you are just going to break even, why go through the motions of exercising the option?

There are degrees of "moneyness". An option described as "deep in-the-money" has a very high intrinsic value. One that is "deep out-of-the-money" - some would say "underwater" - has no realistic chance of ever being worth anything.

An option can just as likely be "near-the-money" though, and any movement in the market value of the underlying stock could be the difference between a gain and a loss for a near-the-money option.

Therefore, an option that is out-of-the-money but still near-the-money has no intrinsic value, but it might still have some market value because the length of time before the option expires could move it solidly in-the-money.

Automatic Exercise
The OCC will automatically exercise a long position that is in-the-money on the expiration date. To ensure that gains are not erased by transaction costs, those positions must be in-the-money by at least ¾ point for an individual investor or ¼ point for an institutional investor.

The number of transactions, within a class or series, which have been opened but have not yet closed are known as the open interest of the class or series.

Graphical Interpretations for Calls
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