Learn First; Trade Later

Education Comes First

Trith s. Belief
Knowledge Comes from Education. Google Images

Question from a reader:

If I write out-of-the-money covered calls, and the stock rallies and hits the strike price, isn't it almost a given that the option owner will exercise the call and my stock will be called away (i.e., sold at the strike price)?

Of all the questions that I receive – and I appreciate each and every one of them – this specific question bothers me more than any other because anyone who asks this question is not ready to be trading options.

Not now, and (yes, this is a harsh statement) possibly not ever.

You must have some idea about how options are priced in the marketplace before you begin trading them. That requires an understanding of the most basic concepts of using options and having a feel for which factors count when determining what an option is worth. With that understanding, you would know that no one in his/her right mind would ever -- and I mean ever -- exercise a call option just because the stock "hits the strike price."

There are several reasons why this is true, but these three should make this clear:

1) You clearly assume that covered-call writers sell only out-of-the-money options.This is not true and many traders sell options that are in the money -- and that means the stock has hit the strike price -- when the option is sold (written). Note: The buyer of your option has no idea that you are a covered call writer, nor should he/she care.

He exercises the option when it is in his/her best interest to do so, and unless there is a sizable dividend, that means never exercising prior to expiration. 

Another way to answer your question involves looking at the open interest (OI) data for all options on the stock you are trading. Obviously, no one exercises options that are out of the money.

But look at the OI for options that are already in the money. Do you see that OI is neither zero nor near zero? That is all you have to know to understand that traders do not immediately exercise call (or put) options once they are in the money. Another point: Look at the trade volume and you will see that people trade in-the-money options -- at prices above their intrinsic value. That would never happen if the options were immediately exercised. Why? Because once an option is exercised, the premium is lost and the exerciser own stock (bought at the strike price).

2)  Contrary to your belief, it is virtually 100% guaranteed that the call owner will not exercise the option as soon as the stock hits the strike price.

Here's proof. Look at any in-the-money option for a given stock.

I am using a real-world example for very actively traded options -- but it should be easier for you to understand if I hide the identity of the specific stock. Recently that unidentified stock's closing price wast $109.52. 

  a) Looking at the open interest for the short-term Nov 100 calls, I note that the open interest is several thousand contracts. What does that mean in terms of your question? The high OI demonstrates that people who own those calls did not exercise (otherwise, the OI would be zero).

Note that everyone who owned that option did not exercise when the stock price hit, or moved passed $100 (that happened a couple of weeks ago).

Next, I checked OI for Nov 90 calls. These are deeper in the money. Is the open interest zero?  Did everyone exercise his/her long Nov 90 calls when the stock moved past 90? The answer is no, and the open interest is still more than 15,000 contracts.

  b) Let's consider the market price (premium) for the Nov 100 call.  If the call owner exercises the option, he buys the stock at $100 per share when it's trading at $109.52.

Looking at yesterday's trading activity, I see that the call last traded near $19 per contract. Look at this from the perspective of the call buyer. Does it make sense for that buyer to pay $1,900 for the option and immediately exercise?

If he took that action, he would be paying $100 (the strike price) plus $19 (option price), and it would cost $119 per share. Who would do that when stock can be bought for $109.52? Obviously, no one would do that.

And if he bought that call at a much lower price (say, two months ago), he would sell at $19, and not exercise -- which is effectively the same as selling the option at $9.52.

  3) The call owner has limited risk. And he paid a premium for owning a position with limited risk. If the stock price tumbles, the maximum loss is the cost of the option. Once the option is exercised, the investor owns stock -- and that comes with a very large loss when the stock price tumbles. It would be insanity to pay for limited risk and then sacrifice that premium to own stock with its (essentially) unlimited risk. 

If you still do not understand why no investor or trader would ever do as you suggest, then you have no business trading options. It will be very difficult to make money when the most basic concepts are foreign to you.

Please take this advice: Learn the basics. Then trade. There is no rush because you have the rest of your lifetime to trade options and now is the time to get your education.