In-The-Money Options help?

Question

Say you write out of the money options and they end in the money. If your broker automatically exercises for you what happens exactly? You'll buy the stock at market value, but then can you turn around and sell it right back at fair market value or will you only be able to sell it for that lower strike price? Seeing as only 15% of options get exercised and have to get sold for the cheaper strike price; can u just sell the remaining 85% back at fair market value immediately? I would love some help.

zman, thanks for the great response; i wouldn't mind picking your brain a little more about options. I think I have a decent grasp but then I'll examine a strategy and get confused. Now on covered calls (and this is for anybody that can help); correct me if I'm wrong but if it is exercised, you get the full option premium correct? So for example a stock worth $100 has goes to $110 and you wrote covered calls for the 105 strike price for $5.00; you would still receive the $500 premium even though it was exercised, correct? Thanks everyone.

Answer 1

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First, if you write options neither you nor your broker can exercise them. Only option holders (buyers) have a choice about exercising options. Option writers (sellers) agree to meet their obligation if they are assigned, but have no control over the process.

Second, an option holder can always specify if he wants the options exercised or not. If an option holder does not give explicit instructions to his broker about exercising the option, the Option Clearinghouse Corporation (OCC), not the broker, will automatically exercise any option that is at least five cents in the money at expiration. If the holder has specifically specified he does not want the option exercised it will expire worthless even if it deep in the money.

Third, if a holder exercises an option and a writer is assigned, the stock is traded at the strike price, not the fair market value. So, assuming the strike price is $50

- If you exercise a call option you previously purchased you will buy 100 shares for $5,000

- If you exercise a put option you previously purchased you will sell 100 shares for $5,000

- If you are assigned a call option that you previously wrote you will sell 100 shares for $5,000

- If you are assigned a put option that you previously wrote you will buy 100 shares for $5,000.

If does not matter if the stock is trading at $5 per share, $500 per share, or anything else. The only thing that matters is the strike price.

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Once the option has been exercised/assigned the option contract no longer exists so there is no longer any strike price involved. If you end up with a stock position (long or short) you can trade it as you would any other stock position when options are not involved, at the current trading price.

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For all practical purposes 100% of options that are out of the money at expiration expire worthless and 100% of options that are in the money at expiration are exercised/assigned. Consequently if you have a position of 1,000 option contracts at the same strike/expiry, you can expect all 1,000 to be exercised/assigned if they are in the money or all 1,000 to expire worthless if they are out of the money.

The reason that only 15% of options get exercised is that most people close their option positions prior to expiry.

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As a note, I will add that pumpdatiron's answer is confusing because he incorrectly states that if you write a naked call and get assigned you have to come up with the money to buy the stock. If you write a naked call and get assigned you sell the stock instead of buying it, leaving you with a short stock position. It is only when you close the short stock position that you have to come up with the money to buy the stock, which can be months or years later.

Answer 2

Writing naked calls is dangerous if the stock takes off. You would be assigned the stock if you wrote calls and they were in the money on expiration day. You would get the stock assigned to you and have to come up with the money to pay for it. Usually 100 shares per contract. You could also buy back the calls before expiration, at a loss of course, but it would prevent assignment. If assigned, you could then hold your stock, or sell at any time after taking possession. As far as your 15% comment, that is a general consensus of traders that 85% of options expire worthless. It has nothing to do with an assignment. You are responsible for 100 shares per contract. Options are very risky. I suggest reading some basic website articles on trading. If you get more serious buy Options As A Strategic Investment by MacMillan.