Options course · Lesson 10 of 10
Know the exit rules before you trade an option.
The formula sets the price. The risks in this lesson come from leverage, from assignment and from the rules of exercise.
Close the trade, do not exercise it
You do not have to wait for expiration. You can sell an option that you bought, or buy back an option that you sold. In the model, a call on a stock with no dividend is always worth more than its intrinsic value before expiration. So a sale at the model price gets more than an exercise.
Take the 95 call with 30 days left and the stock at $100. It is worth $6.21. If you exercise it, you get only the $5.00 of intrinsic value. You lose $1.21 of time value, which is $121 a contract.
Assignment can come early
The owner of an American-style option can exercise it at any time before expiration. So a seller can be assigned on any day. The OCC sends each exercise notice to a broker with a short position, by a random process. The broker then selects a customer.
The risk is higher for a short call that is in the money just before an ex-dividend date. If the dividend is larger than the time value of the call, the owner can exercise early to collect the dividend.
In a spread, an early assignment on the short option leaves the long option open. You must then decide what to do with it.
Expiration is automatic
At expiration, the OCC exercises an equity option that is in the money by $0.01 or more, unless it receives other instructions. So an option that ends a few cents in the money can become 100 shares in your account. A short option can be assigned the same way. If you do not want the shares, close the position before it expires.
Leverage works in both directions
| Stock move by expiration | Return on the stock | Return on the 105 call |
|---|---|---|
| -10% | -10% | -100% |
| 0% | 0% | -100% |
| +10% | +10% | +51% |
| +20% | +20% | +353% |
The 105 call costs $3.31 a share. If the stock rises 20%, the call returns 353%, against 20% for the stock. If the stock does not move, the call loses 100%. A small cost buys a large exposure, and all of that cost can disappear.
A short call has no limit on the loss
The seller of the 105 call receives $331. If the stock rises to $150, the seller loses $4,169. At $200, the loss is $9,169. There is no limit, because the stock price has no limit.
Some option sales can cause unlimited losses. A covered call does not, because the shares cover the duty to deliver.
Costs that the model leaves out
The model uses one price for each option. A real option has a bid, at which you can sell, and an ask, at which you can buy. The gap between them is a cost on each trade. Commissions and taxes also reduce the result.
Before your first trade
- Your broker must approve your account before you can trade options.
- Read Characteristics and Risks of Standardized Options. Investors must read it before they buy or sell an option, and brokers must give it to customers.
- Options have their own tax rules. IRS Publication 550 explains them in its section on puts and calls.
Key points
- Close a position to keep its time value. Early exercise throws it away.
- A seller can be assigned on any day, and the risk is higher before a dividend.
- Know the largest loss of each trade before you open it.
Sources
- OCC, Characteristics and Risks of Standardized Options, for the document that investors must read before they trade.
- SEC, Investor Bulletin: An Introduction to Options, for the definitions of calls, puts and assignment, and the 100-share contract.
- OCC, Trading Options: Understanding Assignment, for American and European style, and random assignment.
- FINRA, Trading Options: Understanding Assignment, for broker approval and assignment in a spread.
- SEC Release 34-57163, OCC expiration date exercise procedure, 2008, for the $0.01 threshold.
- Fidelity, How dividends can increase options assignment risk, for early assignment before an ex-dividend date.
- IRS Publication 550, Investment Income and Expenses, for the tax rules on puts and calls.
- Fischer Black and Myron Scholes, The Pricing of Options and Corporate Liabilities, Journal of Political Economy, 1973, for the model that gives every price in this course.