To exercise or settle an option

jace_da_face

Hi all. I am considering trying my hand at a little option trading but I am still struggling a little to understand how to close out an option to realize a profit as opposed to exercising the option.

For example;

I purchase a call of XYZ stock. It is in the money approaching the expiration date. At expiration I want to realize the profits from this option. For a cash settled option I simply settle for cash. However I believe most stock options are physically settled. I could just exercise my right to purchase the underlying stock in order to sell it for a profit. But say I don't want to hold stock, not even for a short time and I might not even have the margin to cover the purchase of the stock.

In this sittuation I can some how just close out the transaction by offsetting the call? So I just sell the call option. This somehow then allows me to realize the profit? I am finding it difficult understand how this actually works. Most information I've read seems to brush over the exact detail of this very quickly.

Firstly, if I sell the call, I am now an option writer with obligations which is a sittuation I never wanted to be in. All I want to do is realize the profit of my option which is in the money and I would rather not exercise my right to buy the stock if it was not necessay. Secondly, if I sell a call the day before its expiration day who's going to but it? At that stage there is very little time value left on the option so the option's value is its intrinsic value (i think). So why would anyone buy this?

The only way I could see how this could work would be if your right as a holder of a call option to buy the underlying stock before expiration now becomes your right to sell back the call to the writer who sold it to you. You then realize the profit and the writer funds that profit. And if this is the case, then really it is just a cash settlement, even if the option was defined as physically settled. Am I correct in this? And can every option contract be closed out like this?

strmin

You're correct.

If you bought a call option and now it is in the money, just sell before it expires to make profit on it. There is always a buyer waiting to cover loosing call option in order to keep shares.

jace_da_face

And if I did sell the call before expiration then do I become a call writer? And in so doing could I be assigned the obligation to sell stock for less than its true value should the option suddenly become out of the money at the last minute?

strmin

It is simple math. If you buy 1 call and then sell 1 call before expiration you have 0 calls left. If you sell call without buying it first (covered or naked call)
you are call writer.

OfflerCrocGod

Why do you want to use options? What's wrong with the alternatives? Don't leverage beyond safe limits due to greed or you may be wiped.

jace_da_face

Thanks strmin. That was straight to the point.

Now regarding options, well from what I have learnt about them they seem much safer than the alternatives. Why spend upwards of a couple of grand on stocks when I can spend a couple of hundred (or less) on the option to buy them should the share price move favourably. If the option expires out of the money I lose a small premium. That's a safe punt in my book. If the option is in the money I gain a much bigger percentage than had I owned the stock. That's surely the best leverage?

jace_da_face

Ok so now I want to open a trading account. Preferable an Internet based trading account suitable for low volume trades with low commissions and fees. I had planned on trying the Interactive Brokers until I realised you need to deposit 10,000 US as a minimum.

I only plan on buying a few options and will not need to cover big margins. Can anyone recommend a good online brokerage?

neris

Zecco do options tardes. American based broker and easy to open an account with online. Havent done options with them yet but their fees are low enough

strmin

jace_da_face wrote: »

Ok so now I want to open a trading account. Preferable an Internet based trading account suitable for low volume trades with low commissions and fees. I had planned on trying the Interactive Brokers until I realised you need to deposit 10,000 US as a minimum.

I only plan on buying a few options and will not need to cover big margins. Can anyone recommend a good online brokerage?

Before you open brokers account I recommend you to spend few months papertrading. Buying options is extremely risky type of investment. Most options expire worthless and you obviously know very little about them. Do yourself a favor and learn EVERYTHING about options before you even consider placing real order. It's a risky business even for experienced traders. If you made bad investment in shares you can wait and wait until share price recover, but if you wrong in options you go to 0 very quickly.

jace_da_face

Thanks will check Zecco out.

And thanks for your advice strmin. Apart from my obvious ignorance in the field, my game plan is quite simple. And that is to start off small. A simple trade or two over a period of about 4 months. Buying a long call seems a simple strategy to me. I do not see a danger in a simple strategy such as that. I purchase a couple of calls/ puts for a premium of no more than $100 a piece. Unless I am missing something that is extremely safe. I stand to lose no more than $200. Surely it is far far safer to speculate on straight calls and puts than to spend far more on shares. If one of these options is in the money, I get to profit as much as I would have had I bought 100 shares. That is the whole point of options is it not? Limited and minimal risk with much greater leverage. I think it much safer to buy the option on a 100 shares for $100 than to buy 100 shares for thousands.

I don't wish to underesitimate the complexity of more advanced strategies and I certainly do not claim to understand them enough. So you are quiet right, knowledge is power and I would intend to practice. The best way perhaps might be to practice through internet brokers demo/ trial interfaces.

I will check Zecco out to see if this is possible.

OfflerCrocGod

strmin wrote: »

Before you open brokers account I recommend you to spend few months papertrading. Buying options is extremely risky type of investment. Most options expire worthless and you obviously know very little about them. Do yourself a favor and learn EVERYTHING about options before you even consider placing real order. It's a risky business even for experienced traders. If you made bad investment in shares you can wait and wait until share price recover, but if you wrong in options you go to 0 very quickly.

Please listen to this advice. If you want lower risk trading then I'd suggest futures as they cost nothing to keep open and you can keep rolling them forward and given patience you should be able to recover most positions. Once an option expires it's worthless and you've lost the money. If you don't have $10K to open an account I'd save it and paper trade in the meantime.