I understand that a call option might has two elements of value. If the share price rises obviously there is value there.
Then secondly, the time between now and the expiry has value because anything can happen.
But that as the time runs out the only value left, if any, is the share price less the
option strike price.
Good summary.
I can also see how the call option itself trades up and down daily as the underlining share price
moves and the time runs out. In a sense I am fighting both the share price and the time clock.
Riskier than old fashioned buy and hold. Although there are more sophisticated strategies like
selling puts, collecting premiums and laddering and things which if one had skill and interest could
dramatically reduce risk and improve returns.
As with anything else, yes, they trade up and down daily.
But there is no necessity to try to figure out what that price movement will be.
As you note above, come expiry date the only thing that matters is the stock price relative to the strike price.
If I buy a call option, what happens on the day of expiry if no action is taken if the share price
is higher than strike. Does the broker automatically exercise the option for you(A)? Or (B) is it
possible for an otherwise profitable option contracts to expire worthless?
As to what happens on expiry date:
It used to be pretty variable, but most brokers have settled on the following rule:
If the option isn’t in the money, well, it just disappears from your account because it’s worthless.
If the option is in the money, they exercise it for you automatically.
(Some brokers do that only if it’s in the money by at least a coupe of cents)
If that option exercise transaction uses up more cash than is available in your account that day (cash plus available margin if any),
they immediately sell that stock when the market opens and credit you the proceeds of that sale.
Maybe they sell all the stock, maybe they sell only the portion needed to cover the margin shortfall…it’s hard to say.
It’s best to assume that they will do whichever outcome is worst for you.
The lesson is simple: the best rule is never to own an option that you couldn’t exercise if push came to shove–some way to cough up the cash.
But if you do (I do sometimes), then at least don’t own it just before expiration.
Generally that means you sell it and buy a different one with the proceeds to buy more time to let your investment thesis work out.
Here is a specific example.
At market close on Friday, Jan 2024 $150 calls could be bought for about $138.50.
Those offer 2:1 leverage with implied interest rate 5.64%/year on the borrowed half, for a year and a half.
That is, you get the upside on twice as many shares as you would by putting the same cash into stock today.
Subtract whatever you think inflation will be, to get the real interest rate cost.
The stock price has to rise a nominal 2.8%/year for you to break even. (with 2:1 leverage, you’re only borrowing half the nominal stock value)
On one hand, nobody knows whether stock prices will be high or low a year and a half from now. Life is uncertain.
But on the other hand, given recent inflation figures, that doesn’t seem to be a huge hurdle rate.
As with anything else, the order of steps is important.
First, pick a reliable underlying security for your investment.
Second, pick a moment with an entry price that offers good return prospects…a margin of safety of some sort.
With those first two steps you’ve identified a viable investment opportunity.
Then, and only then, think about the best way to have exposure to the security.
That might be buying the stock. Or, for the aggressive, it might be buying a call option if the implied interest rate is reasonable relative to the stock prospects.
At the moment I think Berkshire call options meet all three tests. I might be wrong.
Jim
