
Question By Mario
"How Do I Pay For Exercising Call Options?"
When selling or exercising my call option, do you need to only pay for the premium or the stock price + premium as well?
Asked on 5 July 2011

Answered by Mr. OppiE
Hi Mario,
First of all, selling and exercising call options are two completely different activities that has completely different procedures in options trading. As such, lets explore both scenarios individually.
Selling profitable call options is what all professional options traders prefer to do. This is because selling profitable call options allows you to salvage extrinsic value remaining in them which will immediately evaporate if you exercise those call options. As such, unless there is a very strong reason to own the underlying stock despite losing a fair bit of profitability, almost all options traders would simply take profit on profitable call options by selling them. Selling call options is exactly like selling a stock. All you have to do is use the SELL TO CLOSE order and the call options will be sold off without further payments or obligations.
Example of Selling Call Options
Assuming you bought 1 contract of QQQ's $44 strike price call options when QQQ was trading at $44 for $1.00.
Total price of call options bought = $1.00 x 100 = $100.
Assuming QQQ rallies to $45.50 within a few days and its $44 strike price call options rises to $1.80 and you sell to close those call options.
Amount you get for selling = $1.80 x 100 = $180.
Therefore you make $180  $100 = $80 in profit.

In Options Trading, Exercising profitable call options allow you to buy the underlying stock at the strike price of the call options. Now, call options do not necessarily need to be in the money in order to become profitable. You could have also bought out of the money call options which has gained in value without getting in the money in the first place. In this case, you would certainly not exercise the call options in order to take profit but simply sell them for the profit. This is because exercising out of the money call options will make you buy the underlying stock at a price HIGHER than the market price which results in an instant loss.
Assuming you own a profitable in the money call option and wish to exercise the options for the underlying stock, what happens is that your call options would disappear from your account so that you can buy the underlying stock at the stated strike price. Yes, you will have to fork out payment for the underlying stocks, the stocks do not go into your account for free. Remember, call options gives you the RIGHT to buy the underlying stock at the strike price. It does not give you for FREE the underlying stock at the strike price. Yes, there is no free lunch in options trading. Lets see an example of how that works.
Example of Exercising Call Options
Assuming you bought 1 contract of QQQ's $44 strike price call options when QQQ was trading at $44 for $1.00.
Total price of call options bought = $1.00 x 100 = $100.
Assuming QQQ rallies to $45.50 within a few days and its $44 strike price call options rises to $1.80 and you decide to exercise the call options for stocks of QQQ.
Step 1: Upon exercise, your 1 contract of call options disappear from your account, taking its present value of $180 with it.
Step 2: You now buy 100 shares of QQQ at $44 for a total price of $4,400.
Step 3: Since QQQ is trading at $45.50 now, your QQQ stock position automatically makes a profit of $4550  $4400 = $150
Step 4: Since you paid $100 to own those call options in the first place which evaporated with your exercise, you made a profit of $150  $100 = $50

Comparing the two examples above, you can clearly see that you would have made slightly more profit by selling the call options and have no further exposure to the movements of QQQ than exercising it and continue to be exposed.
Furthermore, profitable call options might not necessarily remain profitable once exercised if the underlying stock has not reached the breakeven point of the position yet. In such cases, the only way of taking profit is to sell the call options. Here's an example:
Example of Unprofitable Exercise
Assuming you bought 1 contract of QQQ's $44 strike price call options when QQQ was trading at $44 for $1.00.
Total price of call options bought = $1.00 x 100 = $100.
Breakeven point for exercising = $44 + $1.00 = $45. (for details of this calculation, please study the full tutorial on Buying Call Options.)
Assuming QQQ rallies to $44.50 within a few days and its $44 strike price call options rises to $1.25.
If you sell the call options
You gain $1.25  $1.00 = $0.25 x 100 = $25 profit.
If you exercise the call options
Step 1: Upon exercise, your 1 contract of call options disappear from your account, taking its present value of $125 with it.
Step 2: You now buy 100 shares of QQQ at $44 for a total price of $4,400.
Step 3: Since QQQ is trading at $44.50 now, your QQQ stock position automatically makes a profit of $4450  $4400 = $50
Step 4: Since you paid $100 to own those call options in the first place which evaporated with your exercise, you made a loss of $100  $50 = $50 loss

In the example above, you would be profitable selling to close the call options but would have incurred an instant loss by exercising them.
In conclusion, it is almost always easier, cheaper and more profitable selling to close profitable call options instead of exercising them for the underlying stock. However, if you definitely would like to exercise the call options for the stocks, you would have to pay for the stocks at the strike price of call options.

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Response by Mario...
Reply by Mr. OppiE...
