From: ask@cbnews.cb.att.com (Arthur S. Kamlet)
Subject: Re: more options question
Organization: AT&T Bell Laboratories,  Columbus, Ohio
Distribution: usa
Date: Thu, 16 Apr 1992 07:30:05 GMT

In article <1992Apr15.021724.12899@cbnewsk.cb.att.com> lor@cbnewsk.cb.att.com (edward.lor) writes:
>In article <1992Apr14.184426.21030@cbnews.cb.att.com> ask@cbnews.cb.att.com (Arthur S. Kamlet) writes:
>>The commissions will hurt you, but
>>help the friendly broker who will, in fact, exercise for you if left
>>to their own choice.
>>
>>There's sense to this.  Let's say the option is $15 in the money;
>>surely you would not want the option to expire worthless!!

>Another point: is it very difficult to sell a $15 in the money
>option close to expiration date? Why would anybody want to buy
>such an expensive option with little potential return? Say, an increase of
>$1 in the stock is only an increase of 6% in the option premium.

Think of options premiums as consisting of two components: 

   - a time value component -- which gradually decreases as
                    the expiration date approaches
   - an "in the money component" --  which is approx the stock
                        price less the strike price  (but not
                        less than zero)

For example, with IBM at $88

     The IBM May 85s are at 3 5/8

                approx $3 of that is the difference between the
                stock price (88) and the strike price (85)

                With about a month to go, the time value is
                approx 5/8

     The IBM Aug 85s are at 4 7/8

                 The time value is approx 1 7/8.  Since there are
                 4 months we should expect greater time value
                 for the August than for the May IBM 85 call
                 options.


     The IBM May 90s are at 3/4

                 since the options are out of the money, the
                 time value is 3/4


If you had a stock that was $15 in the money, its option premium
would have almost no "time value," and all "in the money" value
on the expiration date.   Let's say we could find IBM Apr 60s (calls)

Well, they expire tomorrow, so they have about no time value and are
in the money by 88-60 = $28.  If there were such beasts they would
carry a premium of, oh let's say 27 1/2. (I'm making up this number
just as an example.)

If you owned these IBM Apr 60s long (that means you bought them; if
you owned them short you sold them and really don't "own" them at
all, but that's a whole other story) they really do have a premium
of 27 1/2 and, in the absense of instructions from you, a broker
would probably violate his fiduciary duty to you if he allowed them
to expire and so become worthless.  So he will exercise them for
you.  If so, you would have just bought IBM stock trading at $88 for
only $60.  You can sell them whenever you like.

Why would anyone want to buy a chance (an option) to get IBM at $60
when it has a market value of $88?

Because the folks in this business (arbitrageurs) buy in enormous
blocks of 25,000 - 100,000 or more shares at a time. Their
commissions on the options as well as the stock are much lower than
poor folks -- like anyone reading this newsgroup.  After buying the
option, buying the stock and immediately reselling, they still make
out OK.  Did you notice the 50c difference between the in-the-money
amount and the option premium?  On 100,000 shares that's $50,000
before commissions, which are a lot less than $50,000.  That's
why they will buy your option from you even as it's about to
expire.

>If so, is exercising the option the only way out?

You are always better off selling the option for a profit, unless
you get incredibly sweet commissions on the buy & sell.
-- 
Art Kamlet  a_s_kamlet@att.com  AT&T Bell Laboratories, Columbus