Day 5. How do options make money through exercising or selling

Hello

Welcome to Tiger Academy - 「Options Academy Column」 Issue 5.

In the previous article, we discussed that to avoid the decay of time value caused by long-term holding of options, we can try to close out and sell them within a short period, avoiding holding until expiration.

However, many friends only understand the logic of profiting from options through exercise and are not familiar with how to make money through closing out. They are also unsure which is more profitable: exercise or close out.

Today, I will address this question for everyone.

1. Two Ways to Profit from Options

1. Exercising

Since most individual stock options are American-style options, meaning they can be exercised on any trading day before the expiration date, theoretically, for option buyers, as long as the stock price is above/below the strike price, exercise can lead to profit.

For example, if a buyer spends $1 to buy a call option contract with a strike price of $10, and the price of the underlying asset rises to $12, the buyer can purchase the underlying asset at $10 through exercise. In this case, exercising the option directly, without considering transaction fees, results in a profit of $2.

It can be seen that exercising options allows for relatively controlled profits, and the profits are intuitive and easy to calculate. However, there are also clear drawbacks. First, the process is cumbersome, requiring declaration through an app and following the stock settlement procedures of the exchange.

Second, exercising the option directly would result in the loss of its time value (only intrinsic value is obtained through exercise). Options prices consist of both intrinsic value and time value. If exercised directly, the buyer only profits from the intrinsic value.

Continuing with the previous example, when the price of the underlying asset rises to $12, let's say the option price also rises to $2.50. In this case, within the $2.50, $2 is the intrinsic value and $0.50 is the time value. If exercised directly, the profit would be only $2, while the $ 0.50-time value would be lost.

Considering the cost of buying the option, the return would be even lower.

Of course, if one wishes to pursue greater possibilities, one can choose to hold the option until expiration and exercise then. The only cost would be that as the expiration date approaches, the time value of the option also approaches zero.

Therefore, when the underlying asset price has favorable changes, it is best not to exercise early. Either hold the option until expiration to seek greater possibilities or choose the second method of profit: close out.

2.Close Out

Close-out refers to the reverse purchase/sale, or in simpler terms: if you buy an option, it is called an opening position, and if you sell it, it is called a close-out position, and vice versa.

Closing out is the most direct and effective, and currently the most common, method of profiting from options.

In theory, since the price of an option consists of both intrinsic value and time value, the profit from closing out is greater than the profit from exercising (as exercising only captures intrinsic value).

For example, let's consider Tesla's stock price at $256.6 and a call option with a strike price of $255 expiring on June 30, priced at $8.3. This includes $6.72 of time value and $1.6 of intrinsic value. If exercised directly, the buyer would only profit $1.6 (intrinsic value).

However, if the option is closed out, the buyer would receive a total value of $8.3 as profit.

2.How to Choose the Timing for Closing Out?

Since, in most cases, closing out provides a higher cost-effectiveness compared to exercising, how should one choose the timing for closing out?

• For option buyers:

After purchasing an option, if the market moves in a favorable direction, the time value becomes crucial. If there are no expectations for larger future fluctuations, holding the option further would lead to significant time value decay. Even if the stock price does not reverse, the option price will quickly fall, eroding the buyer's profit and potentially turning it into a loss. This is also why options can incur losses even when the stock price remains unchanged, as we discussed in the previous lesson.

Therefore, when option buyers have achieved their profit expectations, they should close out or switch to contracts with lower time value as soon as possible.

• For option sellers:

If, after selling the option, the stock price does not experience significant fluctuations or moves in a favorable direction, the seller can continue to hold the option to profit. In such cases, the seller's earnings accumulate over time, but risk management should be considered.

In summary, after selling an option, if the stock price changes favorably, investors can generate higher and more stable returns by continuing to hold it, while carefully managing risks.

If the stock price does not perform as expected, investors can choose to exercise or close out the option at expiration, taking advantage of the significant price fluctuations of options to potentially gain big from a small investment. This is also one of the major attractions of trading options.

In addition, for friends interested in option investment, here is a free Options tour course for you to learn.