A call option is the right, but not obligation, to buy a stated amount of an underlying asset, such as stock shares, for a preset price known as the strike price on or before the call's expiration date. If you own a call option, you have the right to execute it, sell it, or let it expire. Of these, the only one that requires money is execution, which is when you buy the underlying shares at the strike price.
It only makes sense to exercise a call option if the call’s strike price is below the current stock price, a situation called in the money, or ITM. Otherwise, it’s cheaper to simply buy the shares in the open market and sell the option for whatever its worth. If your call is in the money, you can sell it for at least the difference between the stock and strike prices, which is the call’s intrinsic value. You might be able to sell the call for an amount in excess of the intrinsic value, which is called the extrinsic value. Extrinsic value can be significant if there is a lot of time until option expiration. When you exercise an option, you lose the extrinsic value.
Exercising a Call
When you exercise a call, the shares will be delivered to you three trading days later, on the settlement date. You can wait to put money into your brokerage account until the settlement date. If you have a margin account, you need only pay for half the shares and take a margin loan for the rest. However, to get a margin loan, you will need collateral in your account, such as cash or securities.
You might think that you can immediately sell the shares after exercising a call without having money in your brokerage account. This is called freeriding and it is severely frowned upon by brokers and the U.S. Securities and Exchange Commission. You might be fined or a freeze might be placed on your account. If you have a regular brokerage account, you should have the money to buy the shares in place when you exercise the call. If you have a margin account, you will need half the cash on deposit plus sufficient collateral to cover the rest.
Given the reality that you can sell a call for at least the same amount as the profit you would receive by exercising the call and selling the shares, you need only exercise a call if you want to hold the shares. You might be motivated by dividends paid on the shares, which are not paid to call holders. Or, you might consider the shares an attractive long-term investment. A third alternative is to sell a covered call. You receive the call price as immediate income, and if the call is exercised against you, you can simply deliver the shares you already own.
- The Ultimate Guide to The World of Options Trading; Manny Backus
- Can I Make A Living Trading Options?; Tom Mathew
- Options as a Strategic Investment; Lawrence G. McMillan
- Jupiterimages/liquidlibrary/Getty Images
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