With the stock market doing well and a lot of call holders being in the money, I figured some people might be thinking of exercising their calls to capture the gains. However, this is something you do not want to do; you are better off just selling the calls. You will see this if you just calculate the profit between selling the call versus exercising and selling the stock. I thought I’d illustrate why.
Start with put-call parity:
- C = price of call
- P = price of put
- S = market price of the stock
- X = strike price of the option
- PV(X) = present value of the strike price of the option
P + S = C + PV(X)
Re-arrange to solve for the price of a call:
C = P + S – PV(X)
Now, you can look at intrinsic value of the option; this is the value you get from exercising and selling the stock; this is the difference between buying the stock at the strike price and selling it at the market price (i.e. S-X). To add that to the expression above, we can both add and subtract X (to keep the equation balanced):
C = (S-X) + P + [X – PV(X)]
The first term (S-X) represents the intrinsic value. This is all you would get from exercising the call and selling the stock. However, as you can see, the actual option has additional value.
You get value from the built in downside protection – the value of the put (P). In addition, you get additional value from the interest you save by buying a call and deferring your purchase of stock into the future instead of purchasing the stock now [X – PV(X)].
TLDR: You should not exercise a call option early because of the value remaining from the built in downside protection and value of the interest savings. If you want to exit the position and don’t want to hold until maturity, you are better off just selling the option. This is a good tool to help you determine what you should buy/sell your options for:
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.