What's going on YouTube? Welcome to Project Option. My name is Chris and in today's video we are talking about an incredibly important topic that you have to understand.
Over the past three years I have gotten thousands of comments across my YouTube videos and a lot of those comments were regarding exercising options or being assigned on a short option that was in the And my goal today is to completely familiarize you with why options are rarely ever exercised, and because of that, why you should almost never worry about being assigned early on an option. So today, we are completely getting rid of that misunderstanding of, as soon as your option's in the money, you're going to be assigned, because today we are exploring why options are almost never exercised, and why you should also never exercise an option. So let's get started. I'm not going to do a full tutorial on what exercise and assignment are in this video, but really quickly, if I have an option or I own an option, I can exercise that option and convert that option into a stock position at the option's strike price. So for example, if I own a call option with a strike price of $120, at some point in the buy 100 shares of stock at the call option strike price of $120.
So exercising an option is taking your option and converting it into a stock position at the option's strike price. If I exercise this call option with a strike price of $120, since I will basically trade the option, this is the option, I am saying I don't want this option anymore. I want to buy 100 shares of stock.
I give away the call option. I buy 100 shares of stock at the strike price of $120. When I do that, someone else in the world who was short that option, meaning they sold it as an opening trade and they are holding the short call option, they get assigned 100 shares of short stock. So since I'm buying 100 shares of stock at the strike price of $120, someone else has to sell.
those 100 shares of stock and somebody who is selected randomly who is short that 120 call option will be assigned 100 shares of short stock. This is the very core of understanding where options get their value from because at the end of the day an option represents the ability to convert the option into a stock position at the option's strike price. So in my example if the call options strike price is $120 and the stock price itself is at $135, I can use my option to buy 100 shares of stock at $120, which is $15 lower than the current stock price.
And because of that, the options price will include the benefit of buying 100 shares of stock at $120 and selling the shares of stock at $135. So if I do that, I will make a $15 per share profit, and when we multiply that by 100, we get a profit of $1,500. So because of that, the options price will include that profit that can be made from exercising the option, buying the shares at the strike price, and selling the shares at the current stock price. And that $15 per share profit, we actually call intrinsic value.
So if a stock's price... is $15 higher than the call option strike price, that call option will have $15 of intrinsic value, meaning if the option is exercised, you can buy shares of stock $15 below the stock price, and then you can sell them at the current market price of the shares. And since that's a $15 difference, you can make a $15 profit per share. That is called intrinsic value. Now, this is critically important to understand.
Because when you exercise an option, you are only going to make the intrinsic value. So in other words, if you exercise your 120 call option when the stock price is at 135, your gain on that share transaction of buying 100 shares of stock at $120 and then selling them at the current stock price of $135 is $15 per share. So your profit will be $15 per share. From that transaction times 100 shares, your profit is $1,500. But options do not only have intrinsic value.
They also have extrinsic value. And when you exercise an option, it does not matter at all what that option is worth. You are sacrificing that option and you are only left with the share transaction.
So if you exercise a call option, you give away the option, you buy 100 shares at the strike price, and then you can sell the shares at the current market price and make whatever that profit is. But If you gave away the option or you exercised the option and it had significant extrinsic value in its price, then you just burned hundreds of dollars for no reason. And traders would not choose to do this, and this is exactly why options are rarely ever exercised. And because of that, since options are rarely exercised, traders are rarely assigned on short options. So let's go through an example.
to fully explain what I mean by this. And if I seem very serious right now, it's because I am tired of getting this question and we need to get to the bottom of this and we need to get you understanding why options are rarely ever exercised and therefore why you will almost never be assigned on a short option. In this first example, we are looking at a call option on Apple with a strike price of $270 that expires in 37 days. The current price of the option is $46.80, which means the option's cost or premium is 100 times that, meaning the option is actually worth $4,680. And Apple's share price at this moment is $314.94.
Since this call option's strike price is $270 and the stock price is $314.94, We would say that this call option is deep in the money, meaning that the strike price is significantly below the actual price of the shares. And in this instance, you might say, well, I want to buy the shares at $270 per share with my call option because I could then sell the shares at $314.94 and make a huge profit on that. So that's what I'm going to do. I'm going to exercise this call option that is currently worth $46.80 or has a value or premium of $4,680 and I'm going to exercise this call option because I want to buy shares for $270 a share so that I can sell them right away at the current stock price of $314.94.
So what happens when I exercise this option? So this is my call option with a strike price of $270 and it is worth $4,680. I exercise this option.
The option is gone. I now just purchased 100 shares of stock at $270 per share, meaning I pay $27,000 for the shares. But the stock price is currently at $314.94.
So I sell my 100 shares for $314.94. And because of that, I receive $31,494 from selling 100 shares of stock at $314.94. So what is my profit in this scenario?
Well, I just bought 100 shares for $270 per share, paying $27,000 for the shares, and then I immediately sold them at the current stock price of $314.94, meaning I collected $31,494, which means... my profit on that share transaction of buying at the strike price and selling at the stock price is $4,494. So I just made $4,494 from buying at my call strike price of 270 and selling the shares immediately at the current stock price of $314.94. So everything is fantastic, right?
Let's back up one second. I just gave up my option. my call option that was worth $46.80 or had a value of $4,680.
This is the call option. It's worth $4,680. I decided to exercise it, meaning the option is gone. I buy 100 shares at the strike price of $270 and I sell the 100 shares at the current stock price of $314.94, making a gain on that share transaction.
of $4,494. But my option that I just gave up was worth $4,680. So by doing that, I actually just burned about $200 for no reason whatsoever. Even though I made money on the share transaction, I did not make as much on the share transaction as the call option was worth when I did that.
And because of that, I burned $186 because I gave up an option that was worth $4,680. And my benefit from giving up that option was that I bought 100 shares of stock at $270. And then I sold the 100 shares at $314.94.
So my profit... is $4,494, but I gave up an option worth $4,680 to do that. If this sounds like a really bad deal, it's because it is. Now, why does this really matter? Well, let's say I bought this call option initially for $25, meaning the premium or cost when I purchased it was $2,500.
If the premium increases to $4,680. I have an unrealized profit on my call position of $2,180. Okay, so that's great. I could just sell the call option and secure the $2,180 profit, or some people would think that they need to exercise the option because you can buy shares of stock at a deep discount to the current market price, and then you can sell the shares right now, and you'll make a huge profit.
But as we just discussed, if I do that... I would buy 100 shares at 270, sell 100 shares at 314.94, and my profit would be $4,494. But since I paid $2,500 for the call option initially, my profit is actually $1,994 if I bought the call option for $2,500 and it became $44.94 in the money, meaning that if I exercise the option, and buy 100 shares at 270, sell 100 shares at 314.94, which is the current stock price, I will make $4,494.
But since I paid $2,500 for the option initially, if I do that, my net profit is $4,494 minus the cost of the option, which is $2,500, meaning my net profit is $1,950. $294. So if we compare those two scenarios, buying the option for $2,500, selling it for $4,680, that's a $2,180 profit. But when that option was worth $4,680, if I exercised it, I only make $4,494 from buying 100 shares at the strike price of $270 and selling the shares at $314.94.
And since I paid $2,500 for that option initially, and my profit on that share transaction is $4,494, my net profit in that case is $1,994. So scenario one is just sell the option for $4,680 and make $2,180 or exercise the option, lose the option. and make the difference in the stock price and the strike price, which gives me a net profit of $1,994 after accounting for the initial option cost of $2,500. So the difference between these two prices or these two profit scenarios is $186, and that is the option's extrinsic value when I exercised it.
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