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Author: CorporalCarrot Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1200  
Subject: Re: Option exercising Date: 1/26/2005 6:59 AM
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This might be a stupid question, but are options always exercised when the stock price moves through the strike price? I imagine they aren't, since you can buy both in and out of the money options, but I'm wondering how often a seller's options get exercised.

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Dave

You need to check with your broker, but I know for example with eTrade that all options that are more than $0.25 (I think) in the money at expiration will automatically get exercised. I am sure other brokers have similar rules.

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Here's why: I am a subscriber to the Hidden Gems newsletter and would like to sell puts for the recommendations at prices I think are a good buy. The only catch is, if the stock price dips below the strike and the option is not exercised, I never buy the stock. Is this a legitimate concern?

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The difficulty with your strategy is that the auto exercise rule happens only at expiration. And very few options get exercised early. If they move into the money, most people will choose to sell them for a profit rather than put the stock. Therefore your strategy will most likely only work where the stock price dips below the strike and stays there until at least the expiration date. If it falls below strike but is back up over the strike at expiration, there is a substantial chance that you will not get put the stock. In this case however you do collect the premium.

So for example, lets say a stock that is trading for $25 and you sell $22.50 puts for $2.50 in premium income. If the put gets exercised you have effectively bought the stock @ $20 ($22.50 - $2.50). The company announces disappointing results today and the stock price falls to $20.50. Nice one you say. I have bought the stock for just $20. But more likely than not the put won't be exercised until expiration and lets say the market is bullish in the interim and at expiration date the stock is trading at $24. You end up with no stock but have pocketed the $2.50.

Howevr, a much bigger risk you need to be aware of is that if the stock continues falling you will end up paying way over the odds for it. Lets say in our example above at expiration or exercise date the market price of the stock is $18, you are paying over the odds for the stock since if you hadn't written the put, you would be able to buy it cheaper. This is why I don't like put selling as a strategy to accumulate shares. You might not realise it but put selling is a highly leveraged bullish bet on a stock with limited upside (maximum you can gain is your premium) but potentially big downside.

And think about it for a second. By selling a put (which is a bullish bet) you are actually hoping for negative news about the company or some other event to reduce the price in order to fulfill your objective of acquiring shares slightly cheaper than the current price! The difficulty is that at the time you sell the put, you have no idea what that negative news is going to be. What if when it comes along, its news that would make you re-consider whether you want to invest in the company at all??

I'm not saying this will definitely happen but you should be very aware at all times whenever you short naked options that this is risky.

A lower risk strategy that you might consider if you want to buy the stock but would like to reduce your average cost basis, is to sell covered calls. That is buy the stock now and sell calls against it at a price you don't think it will achieve. So lets say our stock above. Its trading at $25 but you think its going to be a bit range bound for a while and the $27.50 calls are trading for $2.50. You can buy the stock for $25, sell calls against it for $2.50 thus reducing your buy-in price to $22.50. Now in this case there is obviously the risk that the stock is over the Strike price at expiration, in which case the stock will get called away from you and your profit is limited to the difference between the current market price of $25 and the strike of $27.50 plus the premium you collect of $2.50 which would be a $5 profit. Thus your breakeven in this case (i.e. the point at which you would have been better just buying) would be $30.

In all cases you need to be aware of the timeframe of the options you sell, since you can find yourselves locked into tricky situations. I would only do it against stocks that are a definite long term hold.

For example, last year I acquired a lot of AMD stock at prices between $10-$14. At the time I was relatively bullish on the stock but as it moved upwards I felt it was getting way ahead of itself. So I sold $22.50 calls against it thinking there was no way it would achieve this. But of course it blew threw $22.50 and hit $25 in a very short period of time. Now I was stuck. I had effectively locked in my sales price at $22.50 and I couldnt exit because I was short the calls and they were now damn expensive to buy back in the market. The stock has subsequently fallen back badly and now sits @ $15.60. Ok I've collected my premium but because I misjudged the pace of the market, I have lost out since I would have been better had I done nothing and just sold out of the stock when it got to ridiculous levels.

Just a cautionary tale. Always be careful shorting options!!!!
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