A call option is a contract that allows you to buy some assets at a fixed price called the strike price. In the case of a stock option, the call controls 100 shares of stock until it expires. To execute a call, you first must own one. The purchase price of a call is called the premium. When you execute a stock call, you are converting it into the underlying stock for the per share strike price. Upon execution, the option disappears from your account, your cash balance is reduced by an amount of money equal to 100 times the strike price and 100 shares of the underlying stock are deposited into your account.
Compare the option strike price to the current stock price. For example, you have a call on XYZ stock with a strike price of $44 a share. The current price of XYZ shares may be below, at or above the $44 strike. If the share price is below the strike price, say at $43, the call is “out-of-the-money.” If the strike price is below the stock price, the call is “in-the-money’” Note that you originally paid a $100 premium to buy the call.Step 2
Trade an out-of-the-money call. You would NOT want to execute the call, as this would cost you 100 times the $44 strike, or $4,400. You can instead buy the stock outright for $4,300 and save $100. You do this by entering a BUY order for $100 shares of XYZ on your brokerage screen. You would then sell the call at its current premium to make back some or all of your original premium. You do this by entering a SELL TO CLOSE order for the call on you brokerage screen.Step 3
Calculate your first alternative for an in-the-money call. Let’s assume the current price of XYZ is $46 a share. Furthermore, assume that the call’s premium has risen to $250. Your first alternative is to execute the call at the strike price, costing you $4,400. This would leave you with a paper profit of $200, since the shares are now worth $4,600. Subtract the calls original premium of $100 to get your net profit of $100. If you immediately sold your shares, your $100 profit would be locked in.Step 4
Calculate your second alternative for an in-the-money call. In this example, you could directly buy 100 shares of XYZ for $4.600 and sell your call for $250. You would have no profit on the shares, but the profit on the call would be its selling premium minus the purchase premium, which is $250 minus $100, or $150. In this example, the second alternative is $50 more profitable than the first.Step 5
Execute the more profitable alternative. If that’s the first alternative, enter an EXECUTE order for your call on your brokerage account. The call will be removed from your account and be replaced with 100 shares of stock. The purchase amount, equal to 100 times the call strike price, will be deducted from your account. If the second alternative is more profitable, enter a BUY order for 100 shares of the stock and a SELL TO CLOSE order on the call. Your cash balance will be reduced by the price of the stock and will be increased by the premium of the call.
Items you will need
- A brokerage account holding at least one call option.
- Be aware of trading commissions. For simplicity, they were omitted from our examples. Expect to pay between $5 and $15 a transaction if you use a discount broker. If the underlying stock is about to pay a dividend, remember that options do not entitle you to dividend payments, so you may want to execute the call to receive the dividend. Note that exercising an option is the same as executing it.
- Don’t confuse SELL TO CLOSE with SELL TO OPEN when disposing of your call. The former rids you of the call, whereas the latter obligates you to create a short position on your call, which is when you borrow the call and sell it for cash, buying it back at a later date to repay the loan.
Video of the Day
- Mike Scanlon's Instablog: Early Exercise Of Call Options
- The Options Guide: Call Option
- Scottrade: Option Strategies
- Options for the Beginner and Beyond: Unlock the Opportunities and Minimize the Risks; W. Edward Olmstead
- Understanding Options; Michael Sincere
- Uncle Bob's Money: Generating Income with Conservative Options Trades; Uncle Bob Williams
- Pixland/Pixland/Getty Images