There are times when the market is just hard to read and that makes choosing specific stocks more difficult. For any investor, striking the right balance between risk and profit is the key to a successful investment strategy. For investors who think they know which way a stock will trend in the coming months but who may not be willing to take the risk of buying the stock outright, options may be attractive investment alternatives.
Stock options come in two basic varieties: call or put. In call options, an investor has the right (but not the obligation) to purchase 100 shares of stock at a predetermined price (the strike amount) by the expiration date. Call options are purchased when an investor believes that the price of the underlying stock will rise. The buyer pays a premium for this right to purchase the 100 shares should the option finish “in-the-money” prior to the expiration date – but he/she is not obligated to purchase the shares should the stock fail to rise in value to the point of being profitable.
When a call option does not finish “in-the-money”, that means the market price did not exceed the strike price at the time of expiration – and the investor loses the premium amount plus any commissions paid. Put options are purchased by investors who believe the current price of the stock will fall before the expiration date and are considered to be “in-the-money” when the stock price is below the strike price (of course for the strategy to be profitable, the option should be in the money by enough of a margin to cover the premium and any commissions paid). But if an option finishes in-the-money before the expiration date, is it always a good idea to purchase or sell the 100 shares at the strike price (i.e. exercise the option)?
The decision of whether or not to exercise an option begins when the investment is purchased. The investor needs to decide in the very beginning what kind of exercise threshold (how much “in-the-money” an option needs to be before triggering a decision to exercise it) to set up with their broker or financial advisor. The exercise threshold must take into account the premium paid for the option, the strike price, and commissions related to selling it. In other words, the break-even point is not where the market price meets the strike price. The break-even point is when the market price is higher or lower than the strike price (depending on whether it is a put or a call) by enough of a margin to cover premiums and commissions. However, technically an option is said to be in the in the money the moment the market value goes higher or lower than the strike price.
But how much an option needs to be in-the-money before exercising depends upon the overall value. The premium paid for an option represents the value of the option at the time it was written and takes into account two main factors: the intrinsic value of the option (market price, strike price, volatility, dividend payments), and the time value. When an investor chooses to exercise an option prior to the expiration date, he is choosing to forego any remaining time value.
As the expiration draws closer, the time value will decrease. Therefore, choosing to exercise an option early, that is $0.50 in-the-money, when there are only two days left until the expiration date would probably be a wise decision. After all, with only two days left there is little chance that the option will rise in value significantly but even a small drop in price could significantly hurt the return on the investment.
However, exercising an option two months early that is $.40 in-the-money may prove to be a poor decision. After all, there is plenty of time remaining for stock prices to increase and drive up potential profit. But, if there are signs that the stock may lose value in the coming months, the investor will be wise to choose to surrender the remaining time value in order to secure profits.
Another big factor that an investor must consider when trying to decide on exercising an option early is the type of investment strategy he/she is using. For instance, if an investor used the “buy butterfly” option strategy, then he would reach maximum profits when the high strike price was reached–anything beyond that amount actually decreases profits!
The best time to exercise an option involves many variables. An investor must take the time to read through the contract signed with their broker to understand how exercise thresholds are set and if they can be customized. Many brokers will “Exercise by Exception” meaning they will automatically exercise an option once a predetermined threshold is met – no matter what date it happens to be or what time value remains on the option. It is up to the investor to specify otherwise if he does not wish to have his options exercised automatically when “Exercise by exception” is in place.
Where profit is concerned, there is another alternative to simply exercising an option when it is in-the-money: selling the option back to the marketplace. The time value is the key factor when trying to decide when or if it is time to exercise an option. For instance, if an option was written with a strike price of $35.00 and the stock is currently trading at $36, the option is considered to be $1 in-the-money. But there is a month left before the expiration date and the option is trading at $2.50 (the premium being charged for investors wanting to purchase the option). The intrinsic value of the option is $1 while the time value is $1.50 ($2.50-$1.00). In such a case, the more profitable route for the investor would be to sell the option back to the marketplace rather than exercise it.
Therefore, the fact that an option happens to be in-the-money is not an automatic signal to exercise the option. The time value is a critical factor to consider when deciding when to exercise an option or whether to exercise it all. Some option strategies also complicate timing for exercising options as maximum profitability is sometimes reached precisely when (and if) the market price reaches the strike amount. Options are definitely recommended only for more experienced investors as there are a lot of complicated choices to make that affect the potential risk and profit of these investment tools.