Let’s assume you bought
one call option. The underlying stock is IBM, the strike price is
120, and the option expires in October. The format used to describe
this call is:
IBM Oct
120 call
You now have the right,
but not the obligation, to pay $12,000 (100 shares at $120 per share) at
any time through expiration day. As the owner of the option, it is
your decision whether or not to actually take possession of the stock.
Let’s assume you decide
to hold this call option and time passes. It is now about an hour
before the market closes on the third Friday of October (expiration day)
and you have to decide what to do with your option.
Scenario one
IBM stock is priced below
the strike price of 120, and the option is out-of-the-money.
You do not want to buy the stock for 120. If you want to own the
stock, you can go to the marketplace and buy it for less. The main point
for you is that the option is going to expire worthless. This
means you are not going to exercise your option and that is has no further
value. You no longer have any right to buy the stock for 120, or
for any other price. You lost the premium you paid when you purchased
the call.
Scenario two
IBM is priced above 120
per share. The option is in-the-money. You can exercise
the call and buy the stock for 120 (less than the current market price).
This is the choice you will make if you want to own the stock in your portfolio
and if you have the money ($12,000) to pay for it.
Scenario three
IBM is priced above 120,
so you do not want to allow the option to expire, because it has value.
If you do not want to hold the stock in your portfolio, or if you cannot
afford to buy the stock, then you can sell the option. Because the
option has value, there are people who are willing to buy it from you.
Do not make the mistake of forgetting you own this call but take advantage
of the fact that it has value.
Summary:
If you own an option there are three things you can do with it
Allow
it to expire worthless
Exercise
it and take delivery of the stock
Sell
it
If the call expires worthless,
you have lost your entire investment (the premium you paid) in the option.
If you exercise the call,
you may have a profit or loss depending on how much the option is worth
and the price you receive when you eventually sell the stock.
If you sell the call you
may have a profit or a loss, depending on the price you receive.
Those are the (only) three
choices you have when you own an option.
Next time we will discuss
the versatility of options and some of the strategies for which options
are utilized.
If the words (in bold)
in this article are unfamiliar to you, please use the glossary
