Quick Option Trading Question

Discussion in 'Options' started by Mr. KISS, Jul 21, 2009.

  1. Mr. KISS

    Mr. KISS

    I'm studying up on options. I have yet to run across a definitive answer to this question.

    Let's say you buy 10 call options that look like this:

    Strike Price: $60
    Premium: 1.55 (total price is $1,550)
    Delta: .28
    Theta: -.01
    Implied Volatility: 25%

    Let's say the stock is trading at $55 at the time of purchase and the option expires in 179 days.

    Let's say you hold the option up to the final 30 days and at that point an even causes the stock to soar to $75 and will probably go even higher right up to expiration. At expiration the stock is at $90.

    So would you not make the most money by exercising the option? Doesn't this mean then, to exercise the option, you would need $90,000 in buying power to buy the 1,000 shares? Or is there a way to take the the $30,000 profit without having to put up $90,000 in buying power?

    I know this is a total newbie question. Thanks for your help.
     
  2. You do not have to exercise the calls to realize the profit. You purchased the calls in the options market and you can turn around and sell them in the options market. With the stock at 75, the 60 calls are deeply in the money and will be worth about $15 (15k total). Leverage or "gearing" is one of the economic benefits of options, in fact, and why many people trade them in lieu of stock.

    Note that options that are in the money at expiration will be automatically exercised, so if you don't want the stock, or don't have the cash/margin to take delivery, simply sell the options before they expire.

    The question of what actually to do with 30 days left and all that unrealized profit on the table (and at risk) and is more wide open, subjective and personal. Protecting profit should be on your mind if you intend to carry some or all of the position to expiration. Always a nice problem to have.
     
  3. Mr. KISS

    Mr. KISS

    But if the stock is at 90 and the strike price is at 60, say 5 days before expiration, wouldn't there be more profit to be made my exercising the option? My understanding is since the delta is less than 1, the option won't be worth $30,000 which is what you would make it you exercised the option and then immediately sold the shares. But you'd need $90,000 of buying power to buy the shares right?

    So would the option be worth close to $30,000, say $25,000, the the $5,000 you "leave on the table" is what you pay for not having the $90K available to exercise the option?
     
  4. Mr. KISS

    Mr. KISS

    Is there some low-cost software out there that you can enter (or better yet it will automatically read) all the parameters for an option for a number of different strike prices and months and you enter what you think the stock price will be at expiration and it will show you what the option would be worth over time (assuming the stock price changes linearly)
     
  5. Mr. KISS

    Mr. KISS

    Okay, I get it now. The intrinsic value of the option will be $30,000 at expiration so I still get the same profit. The only benefit of exercising it is that I could then hold the stock for over a year and pay long term capital gains instead of short term.

    What I don't understand though is why someone would buy the option from me for $30,000 when it is about to expire?
     
  6. Using my Option Calculator here are the results of this "trade"...

    60 Call with 179 days to exp @ $55 stock price.
    Actual value would be $4.57 per option.

    At only 30 days left and $75 stock price.
    Actual option value is now $15.10

    That should be a profit of $10.53 per contract.

    At expiration Stock price @ $90 the option value would be $30 per contract.

    KISS (Keep It Simple). Just Buy and sell the options, unless you have the CASH to exersice at expiration. When you ride it out to exp you burn thru all the time premium. No reason to make it complicated.
     
  7. Mr. KISS

    Mr. KISS

    Let me give a little insight. The trade I am looking at is a hedge against the Swine Flu becoming a major disaster like the Spanish Flu of 1918. One might argue if there is that big of a disaster, the markets will tumble but a study done by Fidelity for all the major flu outbreaks since the S&P was created showed the markets didn't crash, even during 1918, not even close.

    The expiration would be in December or January giving plenty of time for the flu to take hold and the demand for vaccine to go through the roof. So at 30 days out, the event will already be in progress and most likely the stock price will only continue to rise.

    Your own analysis there shows that if I sold the option 30 days out, I would make 1/3 the profit than if I exercised it at expiration.

    But the answer I got before is that I should be able to sell the option for near the $30K at expiration because of its intrinsic value. So either way, I don't need the $90K to buy the shares.
     
  8. I see. Great idea.
    If you need an option calculator to plan out different scenerios, there is a FREE on I downloaded last year.
    Just google "www.optionsedge.com".
     
  9. Delta has to do with how much the option changes for each point of change in the underlying. At 30 points ITM, the delta is 1.00 and it will track dollar for dollar.

    Unless the option is trading below parity, you will always get as much (if not more) from selling the option rather than exercising it. Plus, there are fewer commissions and less slippage.
     
  10. donnap

    donnap

    Hmm... I haven't used an options calculator for a while, but his numbers give a option price of about 2.00 or an IV of around 22 according to my calc.

    What parameters did you use to get 4.57?
     
    #10     Jul 21, 2009