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Options University’s Options 101 - Part 44

Filed Under Options 101 

Open interest is generally used as a liquidity guide for trading purposes, especially if you are placing large dollar amounts into a particular option. For example, McDonald’s is currently $29.02 and the July $30 call (one week to expiration) has an open interest of 6,692, which is a relatively large number when comparing absolute open interest figures. It might appear as though this option is very liquid. However, a better method is to take the 669,200 shares that it represents and multiply it by the market price of the option. Whether you use the bid, ask or last trade usually won’t make a huge difference unless there is a very high bid-ask spread. The asking price on this July contract is five cents. In terms of total dollars represented in the contract, that’s only 6,692 open interest * 100 shares per contract * $.05 = $33,460, which by market standards is not too liquid.
 
Conversely, the Nasdaq 100 Index (NDX) is currently trading around 1,550 with the December $1,550 call trading about $108 (yes, this index is extremely expensive due to the volatility!). There open interest is “only” 1,578, which doesn’t appear to be too liquid, especially when compared the 6,692 for McDonald’s. But if we take 1,578 * $108 * 100, we see there is more than $17,000,000 represented in this option. When you compare this number to the $33,460 in the McDonald’s contract, you can see that total dollar value is probably a better measure of true liquidity in an option. If you are placing a large order, you may wish to check the open interest figure to gauge the liquidity. In other words, if your order is substantially large relative to the amount of contracts at that strike, it is possible that your order could significantly move the market price. If that looked possible, we would say the option doesn’t appear to be too liquid. This is why many traders wish to check the actual number (by looking at the open interest column) as well as the total dollars represented in that option.
 
However, despite the apparent justification for checking open interest, you must realize that market makers and others stand by ready, willing, and able to provide liquidity. Just because an option may appear to be illiquid does not mean that it is. Chances are any order will get executed quickly and within reasonable limits of the current price. The reason we make this clarification is because we find that many new traders get caught up in deciding if the open interest is sufficiently large for their order. Unless you are entering an order for 50 or more contracts, we wouldn’t even suggest considering the open interest; it’s just not going to matter.
 
 
Early Exercise
Equity options (options on stock) are an American-style option, which means they can be exercised at any time prior to expiration. To many traders, the exercise restriction that comes with European options seems like a negative feature. It seems sensible that there must be times when you would like to exercise a call option early to gain the stock. For example, what if you’re holding a call option and the stock makes a sudden large move up above the strike price? Wouldn’t it be to your advantage to exercise the option and then sell the stock for a sure profit? Many traders believe this, so they do it every day. But it is one of the biggest mistakes in options trading. Traders who exercise call options early end up with more risk while literally throwing money away, which is certainly not a winning strategy. When the drawbacks to early exercise are mentioned in many of our seminars, it is often met with heated debates but the participants quickly find that there are better choices once we give a few examples. The point is that it is instinctual at times to want to exercise a call option early but it is, in most cases, the wrong move to make.
 
To further confuse the early exercise issue, traders who exercise put options early may actually be better off at times. This section fully explains the differences to make sure you are not throwing money away due to illusory beliefs about options and early exercises.
 
 
Call Options
With only one exception, we can say that it is never advantageous to exercise a call option early. The exception would be for those investors who wish to collect an upcoming dividend on a stock. Because option holders do not collect dividends, if they wish to collect it, they must exercise the option in order to take control of the stock. However, most dividends are relatively small and are usually not worth the risk of holding the stock – even if just overnight. For the few times when early exercise might be warranted, we’ll show you when to exercise in the next section.
 
For now, let’s just concentrate on why it’s usually not in your best interest to exercise a call option early if no dividend is being paid.
 
 
Early Exercise on a Non-Dividend Paying Stock
We’ll compare two investors: One buys stock for $50 while the other buys a $50 call for $2. There is no limit as to the amount of money that either trader could make. Each trader’s windfall depends on how high the stock’s price rises above $50. Of course, the call option trader’s profit will always be $2 less than the stock holder since the call trader pays $2 for the right to buy stock at $50, which would make his cost basis $52 if he uses the call to buy the stock. But aside from that difference, both traders have unlimited upside potential.
 
If the stock is trading for $60 at expiration, the stock holder makes $10 while the $50 call is worth $60 - $50 = $10 as well. After subtracting the $2 cost, the $50 call trader makes $8. No matter how high the stock’s price may rise above $50, both traders continue to profit dollar-for-dollar with the underlying stock near expiration. At no point near expiration is one trader better off than the other when considering stock price increases. But now let’s look at the downside, that is, for all stock prices below $50. If the stock falls, the stock holder loses dollar-for-dollar all the way down to a stock price of zero. The $50 call holder, on the other hand, can only lose $2, so there is a very big difference in the way the $50 call and long stock positions behave for decreasing stock prices. Call options have a very small, limited downside risk (the price paid for the option) when compared to that of the stock trader. At expiration, call options win dollar-for-dollar to the upside, but do not lose dollar-for-dollar to the downside.
 
The second chapter showed that this asymmetrical property is one of the main reasons that traders buy calls in the first place. In other words, traders buy call options to avoid holding the risky stock. Traders are naturally drawn to this beneficial feature of calls. They should be. Short-term traders and speculators survive by using stop orders or other types of risk-management techniques and the asymmetrical payoffs of call options provide an automatic risk management tool; the most you can lose is the amount you paid for the option.
 
Traders are completely disregarding this benefit when they exercise a call early. Once you submit exercise instructions, you are swapping the call option for the stock and are now accepting the full downside risk of the stock. That alone should be enough to convince you to not exercise a call early. But there’s more to the early exercise story than just increasing your downside risk.
 
The second part has to do with the time value remaining in the option. Chapter Two (Pricing Principle #3) showed us that an option’s price must always contain the intrinsic value, or S – E. However, prior to expiration, the call option must be worth at least S – E plus some time value (Pricing Principle #4). When you exercise an option, you are only left holding the value between the stock and exercise price, or S – E. For example, if the stock is $53 and you exercise a $50 call, you are better off by $3. However, we know that the option’s price must be worth more than $3. So if you just sell the call rather than exercise it you would be better off.
 
By exercising a call option early, not only do you accept full downside risk in the stock but you also throw away the time value of that call option. To put it in a more distressing way, you throw money away in exchange for accepting more risk! It does not matter how short of a time period you intend to hold the stock, either. Even if you plan to sell the stock the next day, you’re still at risk of some serious negative news announced before the opening bell. It’s important to remember that, with a call option, your purchase price is locked in. It doesn’t matter how high the stock’s price may rise; you will always be able to purchase it for the strike price, so there really is no need to take delivery of the stock early.
 
To be continued……

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