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Hi, just to clarify...if I am holding a call option that is in the money...and I sell to close for
a profit:
1. I have effectively closed my position with the writer of the option.
2. When I sold the option to close it...the person/trader who purchased it opened a new position with the writer.
3. 1 and 2 can occur over and over during the life of the contract.
4. Eventually, as long as the option is in the money, one of these traders in the chain of traders will exercise the option.
Can you help answer these questions from other members on NexusFi?
If you mean, you are no longer involved with anything connected to that option once you sell it, that is correct.
But I think you have a slightly incorrect idea of what's going on here.
You don't really have a direct relationship to the writer of the option at any time. The fact that the option was bought on an exchange takes the direct relationship out of the picture.
For example, if you decided to exercise the option instead of to sell it, the person who originally wrote the option would not necessarily be involved at all. Instead, the exercise is assigned randomly to someone who is on the other side, that is, who is short the call. (Being short the call means that they are a writer.) Someone will be required to come up with the stock, but it is not necessarily whoever originally wrote the call. In fact, you would receive the shares from the Option Clearing Corporation, which guarantees the transactions, and they would go get them from some party who is currently short.
I have noticed that it is sometimes described as simply being between the original writer and the buyer, I suppose for simplicity.
From the Wikipedia article on option exercise:
"Assignment occurs when an option holder exercises his option by notifying his broker, who then notifies the Options Clearing Corporation (OCC). The OCC fulfills the contract, then selects, randomly, a member firm who was short the same option contract. The OCC then notifies the firm. The firm then carries out its obligation, and then selects a customer, either randomly, first-in, first-out, or some other equitable method who was short the option, for assignment. That customer is assigned the exercise requiring him to fulfill the obligation that he agreed to when he wrote the option."
(But if you read the Wikipedia article you need to scroll down to the section on "Assignment and clearing" -- they start out by simplifying the exercise process to make it seem to happen directly between the two original parties: "When exercising a call option, the owner of the option purchases the underlying shares (or commodities, fixed interest securities, etc.) at the strike price from the option seller, while for a put option, the owner of the option sells the underlying to the option buyer, again at the strike price." -- Which is the right basic idea, but leaves out the fact that the way it is carried out is not really between the buyer and a specific seller.)
It's understandable to think you are exercising the option with "your" very own option writer, but you never are, except by accident if he is the one who gets stuck with the assignment.
As to what eventually happens with the option, the OCC will automatically exercise any in the money options at the end of the day on settlement date, and will handle the assignment and delivery of shares the same way.
Yes, it does get complicated, but basically it's simple once you get it.
Thanks for clarifying. I was wondering, when someone writes a call option contract, they can calculate the break even price for the purchaser as strike price plus premium...so basically will expect to be assigned if the stock price rises above this amount. In your scenario, will this break even price hold true even as the contract is trading hands?
If I understand you, the original buyer's premium is his affair. It doesn't carry along with the option.
For example, say some guy bought xyz calls with a strike price of 30. The current stock price was 25, and he paid (making up a number) 2.00 for the call.
The underlying xyz price went down, most of the time premium evaporated, and he sold the call for .50 to me. So he lost 1.50.
His price of 2.00 doesn't matter to me. If the stock goes to 30.50, I'm now at breakeven if I want to exercise. (I may not want to. I just made whatever the difference is between the current option price vs. my .50 purchase price, and I can get that by selling the call now. The current call price has an intrinsic value of .50 -- the amount it's in the money -- plus whatever time value is left, so it will be above my purchase price unless it has no time left at all.) Or, I might want the stock, but I've paid .50 to get into the stock at 30.00 so I'll want to see the stock price above 30.50. The other guy would have had to wait for 32.00.
Once the option goes in the money, it may start to look attractive to some holders to exercise, based on their purchase cost.
Exactly...so the first guy had a break even of 32 (30 strike plus 2 premium)...whereas after the stock went down and he sold it to you for .50, your break even was lower at 30.50 (30 strike plus .50 premium)...Does this not affect
the writer who may be banking on the fact that the price of the stock will not likely reach 32 before expiry, and therefore is not expecting to be assigned? In this scenario he could now be assigned at 31 by yourself...I suppose that since the stock went down...say to 23 then it has to climb 7.5 dollars to hit your B/E price (30.50-23=7.5) whereas originally it had to climb 7 (32-25=7)...so I guess it all evens out.
In general, the writer does not expect to be assigned if at all possible, since he just wants to sell premium to the optimists and have a nice income while keeping his stocks. So he is banking on the option expiring worthless, which most do.
Sometimes it doesn't work out.
I have never been in the writing game, but my impression is that it is done by large and sophisticated institutions who have their costs and risks figured out very precisely, and figure that, on balance, they will extract some additional income on a large portfolio that they are not going to turn over that much.
I don't know that they would have made that original calculation about not being exercised before 32. I don't see why they should. Price will fluctuate.
The seller received the premium of 2.00 on the sale when he wrote it. If I exercise at 31.00, he has to accept a payment of 30.00 for a stock that is worth, at that time, 31.00. So, if he wants to replace the stock in his portfolio, which he probably does, he can take my 30.00, add 1.00 out of the premium he got, and he's still got 1.00 left. But maybe I want to hold on until the stock reaches 35.00, and then I get a 35.00 stock for 30.00, and he gets hurt to the tune of 3.00.
He wanted the stock to never go anywhere, and keep the whole 2.00, plus still have the stock.
Again, not my game, but stuff happens, after all.
My principal point was simply that there is no relationship between the original seller (writer) and the original buyer that is maintained in any fashion after the trade. How all the decision-making is done, how options are priced and all the things that go into the mix, can get kind of involved....
