Options on stocks

[scha2707]

Long time follower first time poster.

I keep reading about people exercising their options on certain stocks. I understand the basic definition of a stock option and how you purchase the option.

But, I do not understand what happens when you exercise the option. Are you actually buying the stock at the option price? Or are you you selling the option contract and making money on the spread difference of the purchase and sell price of the contract?

Thoughts, comments, and examples are appreciated.

[jpg7n16]

Here's pretty much what happens:

Call options: (MSFT Jan '11 $30 call option sells today for $2.20)

Means: "I'll make you a deal. If you pay me $2.20 per share today (in increments of 100 shares = $220), I'll give you the option to buy those 100 shares from me for $30 each any time until the 3rd Friday in January 2011."

The basic exercise of the option: When you exercise, you make the decision to buy them from me @ $30/share. So you purchase 100 shares for $3000. You can then hold them or sell them, that's up to you. But you now own 100 shares of Microsoft.

If the option is still trading (before the expiration day), you may also turn around and sell your option on the open market to anyone willing to buy it from you. That is different than exercising the option, but it is another alternative you have to liquidate the position.

That is your choice.


Edited to add: for tax purposes, your tax basis in the shares would be the $3000 plus the cost you paid for the option to get them at that price, $3,000 + 220 = $3,220 basis in the shares. Your holding period begins on the day you bought the option (for long-term/short-term holding period requirements).

[heidrek]

as you get closer to the date of option exipry, the option would lose value wouldn't it? the chance of being able to exercise the option reducuing over time?

[jpg7n16]

as you get closer to the date of option exipry, the option would lose value wouldn't it?

kind of. the market value of an option is made up of 2 parts: intrinsic value + time premium = market value

The "intrinsic value" of the option is the amount it would make if bought and exercised immediately.

ex1: a $35 call on a stock trading at $40, you could buy at $35 and immediately sell at $40, so it has an intrinsic value of $5.
ex2: $35 call on a stock trading at $30 has an intrinsic value of $0, because if you bought it, you would never exercise it immediately - why use your option to buy at $35 when you can buy in the market at $30??

The "time premium" is whatever is left over. That part of the premium compensates the issuer of the option for the risk that the stock may rise about the exercise price (on a call). Obviously the more time I have my option available, the more value that option is to me.

ex. the Microsoft option above - if I bought that option, I would have around 7 months to see if the stock will get over $30. but what if I only had 2 weeks? MSFT is much less likely to rise above $30 in the next two weeks when compared with the next 7 months. So the 7 month option would be worth more.

But over time, as that Jan '11 expiration date gets closer and closer, my chances go down, so the "time premium" portion goes down.

But if MSFT stock is skyrocketing, the value of my option can still go up, because the Intrinsic Value part keeps rising as the stock does - even though the time until expiration is going down.

the chance of being able to exercise the option reducuing over time?

Nope. Once you own the option, you may exercise it any time up until the expiration date - which is a fixed date in the contract you buy. That date will never change on you, and you'll never have your right to exercise removed.

[heidrek]

So in general you're better to go for long duration options?

[Slug]

It depends on the option and the strategy. Lately I've been selling short-term close to the money puts for small gains. Most expire on May 19. I did sell the October Alcoa 12 during the 1000 point sell-off, but that's as far out as I'm going right now.