Question By Caicanyang
"Instant Profit Buying ITM Call Options?"
Can I buy call option with lowest strike price, then sell it to get profit right away?
Asked on 2 March 2010
Answered by Mr. OppiE
Most beginners to options trading have this same question; "Since call options allow me to buy the underlying stock at a fixed price no matter what price the stock may be, won't I be able to buy a call option with very low strike price, exercise the right to buy the stock at that low price and then sell it at its prevailing market price for a free profit?"
This logic works but the problem comes when you take the price of the call options into consideration. You can make the trades but no profits would result due to the way stock options are priced.
Call options pricing comes in two parts; Extrinsic Value and Intrinsic Value.
In simplistic layman terms, extrinsic value is the extra money you pay for owning the contract and intrinsic value is the value that is already built into the call options itself. You may be getting the idea by now why buying call options won't allow you to make an instant profit. Yes, the amount of value that is built into the call options is already reflected in the price itself so you won't stand to make any profit by exercising it immediately at all. Hence the popular saying "There is no free lunch in options trading".
Instant Profit Buying ITM Call Options?
AAPL is trading at $195 and its call options ($170 strike) are asking at $27.95.
Assuming you bought 1 contract of the $170 strike call options for $2,795 and immediately exercised it, you lose the whole $2,795 (as the call options would cease to exist upon exercise), and bought 100 share of AAPL at $170 for the total value of $17,000. You then sell the shares immediately at its market price of $195 for a profit of $2,500 ($19,500 - $17,000).
Lets look at your net effect:
You lost $2,795 for exercising the call options and then made $2,500 from selling the shares, so you actually made a loss of $295.
In the example above, the $170 strike price call options priced at $27.95 consists of an intrinsic value of $25 ($190 - $175) as it allows you to buy the stock at $25 cheaper than market and then an extrinsic value of $2.95 for the ownership of the call options. This extrinsic value immediately evaporates when a stock option is exercised. So instead of making a profit, you actually lose the extrinsic value and make a loss.
In conclusion, the only way to profit from buying call options is for the stock to go upwards AFTER you have bought the call options. When the stock goes upwards, the call options would gain in value and then you can simply sell the call options for the profit without exercising the call options at all.
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