Example of Exercising versus Trading

Let's look at an option example and the alternatives an option buyer possesses. In February, a trader buys 1 IBM May 110 Call at $5 when IBM is trading at $108 per share. In late April, when the option is nearing expiration, IBM stock is trading around $120 per share and the option's premium has increased to $11K. In this example, because the option is in-the-money, the option holder has the choice of either exercising the option contract or trading out of the long call position. If the trader decides to exercise the IBM May 110 Call option contract, he or she must first inform the clearing firm of his or her intentions. The clearing firm then notifies an IBM May 110 call writer that he or she has been exercised and is obligated to sell 100 shares of IBM stock to the option holder at a price of $110 per share.* The option buyer pays the option writer $110 per share for the 100 shares of IBM, for a total of $ 11,000, giving the trader a long stock position at $ 110 when the market is trading $10 higher. In exercising the long call contract, the trader paid $500 for the rights to the option and $11,000 for the 100 shares of IBM stock, for a total cost of $11,500 on the transaction. If the trader were to immediately liquidate this long IBM stock position, by selling 100 shares of IBM at $120, the trader would receive a total payment of $12,000. Therefore, on the overall transaction, the trader realizes a total profit of $500 ($12,000 - $11,500), excluding any commission costs necessary to purchase the call option, to purchase the 100 shares of IBM stock, and to sell the 100 shares of IBM stock.

On the other hand, if the trader were to trade out of this long IBM call option position by performing an offsetting transaction, the process would be much simpler. To offset the long IBM May 110 Call option position, the trader must sell 1 IBM May 110 Call option. With the prevailing market prices, the option buyer paid $5, or $500, for the rights to the call option and can sell the option at $ 1114, or

* The option writer who has been exercised is not necessarily the trader who initiated the option transaction with the option buyer in the first place. The clearing firm decides how it will match option buyers and sellers. It is important that a trader is aware of the method the firm chooses before he or she decides to write an option contract.

$1150. Therefore, the option buyer realizes a total of $650 of profit on the trade, less any commission that applies for purchasing the call option and later liquidating that option.

In comparison, by trading out of the option position the option holder was able to realize a greater profit on the trade. This is usually the case with options. However, the closer to expiration the option gets, the less a trader will be able to retrieve in premium by trading out of his or her position. It is important that a trader compare the two processes before making a decision as to what to do with the option position.

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