Basic Options Question
I am taking an investment class this summer and just scratched the surface of options and have a few easy questions I need answered.
Do you actually purchase options? The book explained the idea of options, but did not cover the purchase of them.....
The true question related to this is; what happens to your initial investment if you purchase a call option, its out of the money on its expiration date, and you do not exercise it?
This chapter didn't cover it and the internet just explains to only exercise in the money. I am just confused on what happens if you buy it, don't exercise it, and it expires out of the money. Do you just get your principal back or did you not put any up to begin with?
Thanks
Of course you pay for the option. Think about it, otherwise it would be infinite potential upside for no money! If the options expires out of the money you lose whatever you paid for the option in the first place. If it expires in the money, you make money if it is above the strike + price of the option. If you got your principal back you could not lose any money, which doesn't make sense. On the other hand, if you sell an option and it expires out of the money, you keep whatever the buyer paid for it.
Okay. I just got it explained to me more. My confusion was not knowing that you pay an amount significantly less than the share price for the call option. I was trying to understand how to minimize your losses in the even you were out of the money and on the expiration date.
So you pay $3.00 for a call option with a strike of $100, you need the share price to hit $103.01 to be profitable correct? Previously I was understanding that if you agreed at a strike of $100 and it fell to $97.5, you would still exercise and save your self the .50c. Hard to explain how I was thinking about it, but I think I got it now. The correct version of that is that you would exercise at $102.5 and take a .50c loss and at 97.5 you would let it expire and lose $3.00, correct?
I don't know why the book didn't cover that. It just said to exercise in the money and I was like no shit. What do you do if it goes the wrong way on you. Now that I know the call option is "cheap", it makes more sense.
No, remember, option contracts are a form of leverage. If you "exercise a call at $102.50" you're on the hook for $10,250 in shares (1 contract = 100 shares). Unless you actually wanted to buy that many shares at that exact date, you'd sell your option prior to expiration at a loss, not exercise it.
Most all brokerages (that I've come into contact with) let out-of-the-money options expire worthless at expiration. Nobody exercises OTM options at expiration because that would be very very stupid.
Any out of the money option will expire worthless. If you think about it, how much would you pay for an option to buy a stock higher than the market price right now? You would pay nothing because you could just buy the market price
In the real world, occassionally you may decide not to exercise slightly ITM options or decide to exercise slightly OTM options if they are physically delivered. Physical delivery means you receive the underlying if you choose to exercise.
Why would you do this? Isn't it irrational? Possibly not. Take this example, you are long a very big call option that is 1 cent in the money. If you exercise (and don't want to have a delta position) this will mean that you'll have to sell quite a bit of the underlying... and the fill could be below the strike.
you might not want to own the share over the weekend in case it dives hugely, or you might have an ITM option of total value $1m, but your account only has $500k in.
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