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The Hidden Risk of Buying Calls isn't What You Think

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July 1, 2011
hidden risk buying calls
Fredrik Broden

I’ve been trading so long, I can’t exactly remember when I learned the basics about options. You know, what a call is. What a put is. Max profit potential, max possible loss. Exercise and assignment. Like everybody else, I started with the simplest stuff and worked up, and I went a long way with the basics. But one expiration taught me a little lesson that I won’t forget.

One of the first things you learn is that a long call has a maximum risk equal to the debit you pay for it. If I buy a call for 1 point, which is $100 cash, and the stock goes down so that the option is out-of-the-money at expiration, I’ll lose $100 plus any commissions I paid. No more, no less. You’ve heard me going on and on about managing risk, knowing the max risk of a trade, don’t take too much risk, yada yada yada. You’d think that if you buy a call, you could then forget about it because you have the risk under control. What could happen?

Rude Awakenings

I’ll tell you what can happen. I was an index option trader, and didn’t do too much with individual stock options. But once in a while I’d take a shot on something. I bought a call on a stock I thought was going up. I think it cost me half a point. I kept tabs on it, but my main focus was on my index option trading. I’d see the stock rally and come back down, rally and come back down. Expiration was approaching. The option was getting cheaper and cheaper, and I didn’t think it would do much. To be honest, I kind of forgot about it. Hey, my maximum possible loss was $50.

But when I wasn’t watching, the stock closed above the exercise price of the call on expiration Friday. My call was in-the-money by $0.20 or so. Now you might think that was a good thing, and I suppose it could be, because theoretically that call was worth $0.20 and not 0, so my loss was smaller. But my long call was automatically exercised because it was in-the-money at expiration, and I got long stock in my account. On Monday morning, I noticed the long stock (remember, I had kind of forgotten about my long call). So, I checked the price of the stock and ... Crap! It’s down $2!

I sold the stock that day and figured out my loss after the close. I had bought the call for $0.50; the call was exercised and I bought the stock at the strike price, and then I sold that stock at $1.70 below the strike price. I lost $0.50 on the call and $1.70 on the stock, for a total of $220—way more than the max loss on the call!

You see, back when there was a lot more manual stuff going on to handle expiration, long options weren’t automatically exercised unless they were $0.50 in-the-money. But as systems improved, that number dropped to $0.25, then $0.05, and then $0.01. So today if you have a stock-settled option and it’s $0.01 or more int he- money, it’s going to be automatically exercised* unless you call your broker. If not, you’re going to have a stock position. And that stock’s next move can potentially create larger losses than you might have had with just the long call.

The solution: monitor all your positions at expiration. If you have long or short options that are in- or at-the-money, just close them out. If I had been paying attention, I might have been able to avoid the extra risk.

NC
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