Purchasing this option for more than 6.15 makes no sense because you will end up paying more than market value for the stocks...so why is the seller asking for 6.25? If he does not find a buyer, then he would have to exercise the option and purchase the shares to get value from this contract?
Last edited by brags; October 16th, 2015 at 08:32 PM.
Not sure if I understand your question correctly, but I will give it a shot.
Firstly, the option you are looking is at expiry - thus only intrinsic value matters.
Should you wish to purchase the 1,000 shares, i.e. exercise the option, then you would pay 6.25 (ask) for that pleasure. Most ITM options are auto exercised, so your total cost would be 6.25 + 25 = 31.25 per stock equaling $31,250 for the entire trade. In this case, it is better to purchase the stock outright.
The seller of the option, would purchase the stock (since he needs to deliver this to you) at market - 31.15. If the seller is selling the option as part of a covered call strategy, the following math will be different, but to keep things simple, we assume the seller buys the underlying once he sells the option. Since this option will be exercised, you could say that he sold the stock to you at 31.25. Thus he makes $0.1 before his trading costs.
What you are seeing here is a perfect example of transaction costs on a trade. The market maker introduced a spread and based on this spread he can make a profit. As the buyer of the call, you still need the underlying to move sufficiently and cover the spread before you will profit.
In real life these type of trades will hardly ever occur since there is no expected benefit for the buyer. Usually you would buy call options with at least some time to expiry. The more time the underlying has to move, the greater the potential gains on a long-option position can be.
Edit: To better explain the math for the option seller, the calculation is as follows:
The seller of the call makes a loss on the sale of the shares he purchased since he is selling them to the buyer of the call at 25. Loss is 25 - 31.15 = -6.15. However, he received 6.25 for the option, thus total profit of $0.1 per option.
Last edited by grausch; October 18th, 2015 at 09:22 AM.
Reason: Explain math a little better
You are assuming the seller is already long. My first post was if the seller is not already long. If the seller was holding the call from earlier, the math is somewhat different. He could sell his option in the market for 6.05 (the bid) or exercise his option and then sell the stock in the market.
He would need to look at the following to scenarios:
1. Sell the option at 6.05. Profit is 6.05 - purchase price of option
2. Exercise the option and sell the stock. Profit is current share price (31.15) - strike (25) - purchase price of option
In this case, there is a $0.1 difference in favour of exercising the option and selling the stock. However, we are assuming the spread is less than $0.1 on the stock. If it is not, then selling the option would be the better option.
Ok, I am a bit confused about the being long or short part. Let's say that there are 3 people involved in this scenario.
Fred is the original writer, Larry is the original buyer ( current holder), and Pete, who is considering to buy the option from Larry.
So being long or short on the stock would be referring to Fred...who has to cover the call when exercised. Larry purchased the option from Fred when it was otm...so he is trying to collect his profits for that by selling it. Pete is trying to buy the option from Larry at a reduced price so he can purchase the stock at a discount. The fact that Larry did not accept the 6.05 bid means that he is fully prepared to exercise the option and buy the stock from Fred at strike price...otherwise he would have accepted the 6.05 bid to avoid having to exercise it himself...for instance if he did not have sufficient funds to purchase the stock.
Are these reasonable motivations for this scenario? Are there any others?
Last edited by brags; October 18th, 2015 at 09:53 AM.
If Fred is the original writer, then he is short the option. He may or may not be long the stock. A scenario that is seen quite often is where a covered call option trade is implemented, i.e. you already own the stock and are trying to earn a little income by selling an OTM call. In a covered call, the option presents no additional risk to Fred's portfolio, although it could cut short gains on a winning stock. Risk on the stock position is unchanged. If Fred does not own the stock, then his risk is potentially unlimited. If Fred goes short the stock, his unlimited risk just doubled, so his stock position would either be neutral or long.
With regards to Larry's position, he is sitting with a nice profit. If he has enough buying power in his account, he can do the math and determine whether he should a) sell the option or b) exercise and sell the stock. Without sufficient buying power he can only sell his options position. Of course, there could always be other considerations coming into play.
With regards to Pete, if he and Larry can agree on a price, then sure the trade may happen. In real life, this is where the bid and ask spread come into play. Pete would like to buy at the bid and Larry would like to sell at the ask. If they manage to agree on the mid (6.15), then there is no difference for either of them if Pete buys the stock or the option or if Larry exercises the option and sells the stock or if Larry sells his option.
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