Understanding Options: Exercising vs Assignment

Nov 24, 2024

Lecture Notes: Understanding Options Exercising and Assignment

Introduction

  • Speaker: Chris
  • Topic: Why options are rarely exercised and why you should not worry about being assigned early on an option.
  • Goal: Clarify misconceptions about options being automatically exercised when they are in the money.

Basic Explanation

  • Exercising an Option: Converting an option into a stock position at the option's strike price.
    • Example: Owning a call option with a $120 strike price allows buying 100 shares at $120.
  • Assignment: When someone who is short an option (sold it) is obliged to fulfill the contract.

Understanding Option Value

  • Intrinsic Value: The profit potential from exercising the option (e.g., if stock is $135 and strike price is $120, there is a $15 intrinsic value per share).
  • Extrinsic Value: Additional value beyond intrinsic, based on factors like volatility and time.
  • Exercising an option results in losing any extrinsic value.

Why Options Are Rarely Exercised

  • Exercising only realizes the intrinsic value, sacrificing any extrinsic value.
  • Example: A call option worth $46.80 (or $4,680 in premium terms) on a stock with a strike price of $270, when the stock price is $314.94.
    • Exercising leads to a $4,494 profit from share transaction.
    • The loss of extrinsic value means a net loss compared to selling the option outright.

Detailed Example

  • Apple call option with $270 strike price, expiring in 37 days, current option price $46.80, with stock price at $314.94.
  • Scenario Analysis:
    • Exercising the Option:
      • Buy 100 shares at $270, sell at $314.94, resulting in $4,494 profit.
      • Option worth $4,680, exercising means losing $186 (extrinsic value).
    • Not Exercising:
      • Selling the option at market price $4,680 results in $2,180 profit (if bought at $2,500).

Conclusion

  • Selling an option when it holds extrinsic value is generally more profitable than exercising it.
  • The common misunderstanding that options should be exercised when they are in the money can lead to unnecessary financial loss.
  • Key Takeaway: Understand the intrinsic and extrinsic components of option pricing to make informed decisions on exercising or selling options.