Let's look at Jun options for SPY hypothetically. http://finance.yahoo.com/q/op?s=SPY&m=2011-06 Say someone has $2,000 in their account. That's enough to buy 14 shares of SPY, but they think that SPY is going to go to 150 sometime in May and want to make more money. If they outright bought it, they would have: 14 shares of SPY ($133.64 * 14 = $1,870). Say they are right, and SPY goes up to $150 per share. Their 14 shares are now worth $2,100 for a gain of $230. Say instead they decide to buy as many 140 strike call options as they can, currently at an ask price of $0.40. At $40 each, our hero will get 50 options (ignore commissions for now) for a total of $2,000. Now, say SPY gets to $150 sometime in May. Our hypothetical person decides that they don't want to wait until expiration, so they exercise their options now. They now have the right to buy 5,000 shares of SPY at $140, which would cost $700,000. Except our guy doesn't have that much money, so it would seem that buying 5,000 shares of SPY is out of the question, right? If he had the money, he could buy the 5,000 shares and then could immediately sell it for $750,000 (5,000 * 150) netting a profit of $50,000, but what happens here because he doesn't have the money to buy the shares in the first place, even tho he has the right to do so if he wants? Is his alternative to SELL his call options, and if so, will he get roughly $50,000 for them (so they are going to be priced at roughly $10 each)? What happens if no one wants to buy his options? Is he screwed?
Selling the options should be a bit better than exercising and selling the stock. The options will have $10 of intrinsic value, plus whatever time value is left. That's what the .40 was when the call was out of the money. There is a market maker there to buy the option. If he can't unload it on the other end then he will offset it with something else, like shorting the equivalent deltas in the underlying stock.
As the previous poster said, you would normally be better off selling the calls to get the intrinsic value plus whatever time value they have. But suppose the market is perverse and the bid is below the intrinsic value of the call. Is there a way a cash strapped trader can force the market to give him at least the intrinsic value? My understanding is that as soon as you exercise the calls you can then short the stock (before delivery). In such a case, where there is no risk, (the stock will be bought back at the strike price) do the usual margin requirements apply or are they waived? Does anybody know?
You could do a synthetic short, buy a put and sell a call, theoretically for the same price as the option. That is, if the option is supposed to be worth $10+time value, you should be able to do the synthetic for the same credit. Edit: This is a reply to rew's comment.
The reality is that some market maker will be willing to take your options but they might pay 1 -2 cents less than intrinsic (their edge to their delta hedge). But if you had a margin account and let the options expire, you would exercise and get a margin cal immediately on monday morning. assuming the stock doesn't move on monday's open you will do the same. At least Etrade will do this. it is advisable to just take the 1 or 2 cents loss on friday and cut the position vs taking the risk. in single stock options, deep in the moneys are trickier, but someone will trade with you - you might have to give up a few cents.