In keeping with the recent theme, here’s an option trading question I received over the weekend.
Hello John,
Your book is great and has helped me a lot. But now, I’d like to get more into options. As your book put it – put the pedal to the metal.
I’ve read a few books on options already. But, I have a problem. While they all go into the intricacies of what options are, the greeks, and some trading strategies, none of them really have a how-to aspect to it.
Specifically, I am looking for how to close out positions. It is easy to put on the trades, but I am not sure how to close them out.
For example, let’s say I buy a Feb call for XXX stock at $90. At expiration, the price of the stock is $100. So now, I’ve got a profit of $10 per share. In order to take advantage of that, do I have to actually take possession of the stock, then sell it on the open market? Or is there an automated way to do this? Or do I just try to sell a call option and take the profit from there?
Or, even if the stock jumps to $100 a week before expiration and I want to take advantage of the $10/share profit, how do I do this?
Anyway, these are the types of questions that none of the books I have read seem to answer. So, my question to you is, do you have a book or a course that answers those specific types of questions?
Thanks very much.
Hector T.
There are two ways to close out a stock option position. Actually, there are three, but I won’t count letting an option expire since that really doesn’t require any action on the trader’s part.
Exercising the Option
One of the ways to close an option trade is to exercise the option, as Hector noted. That means telling your broker you want to do so. Using the above example of the XXX $90 call, exercising would me that you buy the stock from the option seller for $90. You can then sell that stock at the current market price, presumably making a profit.
It must be noted, however, that certain types of options only allow for exercise as specific times. An American style option has no restriction. You can exercise it any time from when you buy it right up to expiration. European style options, however, can only be exercised at expiration. There are also Bermuda options which have specific periods when exercise is permitted. They are a kind of blend of American and European.
It also should be noted that expiration doesn’t necessarily mean there’s no execise of the option you hold. In some markets if you hold an option to expiration you will automatically be exercised at expiry, if it’s in the money, unless you provide instructions otherwise. That means you’ll end up with an active position. Make sure you are aware of how expiration is treated in the market you trade.
Selling the Option
In most cases, exercising is actually not the best approach when you want to close out an option position. Normally, the best way to close a long option trade is to simply sell the option in the market, just as you would a stock position you were holding.
Consider Hector’s example again. If you were to exercise the call option and sell the stock for $100 you would make $10/share. That’s pretty straightforward. You would, however, have to take the cost of the option out of your net profit, so you would actually make something less than $10/share.
Now consider the price of the $90 option when the stock is trading at $100. It’s going to be trading at something greater than $10 because it has $10 in intrinsic value. How much above will depend primarily on implied volatility and the time left to expiration. That means you will end up with more bottom line profit if you sell the option than if you exercise.
To put that into numbers, assume you paid $1 for the $90 call. If you exercise the option you end up with $10 – $1 = $9 in profits (transaction costs aside). Now let’s look at selling the option. It’s going to trade somewhere above $10. Even if it’s just $0.01 higher, you still come out better off. Selling the option gets you $10.01 – $1.00 = $9.01 in profits.
Of course, if the option is out of the money, then exercising the option makes no sense at all because you’ll lose money on selling the stock in the market. There again, selling the option is the favored approach.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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