To Exercise, Or Not To Exercise (Options), That Is The Question

In a previous article, I explained commodity option expiration, exercising, and assignment. I noted a long (purchased) option position (call or put) has the right to exercise the contract. To make an informed decision, I will explain the result of exercising an option contract.

A commodity option contract is a decaying asset that will expire. As an option contract draws near its expiration date, set by the exchanges, both the time value and intrinsic value diminish. Time value is premium in relation to days until expiration. Intrinsic value is the premium in relation to the strike price’s distance from underlying futures contract price. Note that volatility will also play a role in the calculated premium price. The exception to intrinsic value diminishing is an in-the-money contract. At that point, the intrinsic value is a one-to-one ratio of the strike price in relation to the underlying futures contract. For example, a long April 2013 Gold 1600 call will be valued at 50 points (or $5,000) if futures are at 1650.0 on option expiration (March 25, 2013). On the other hand, if futures are at 1600.0 or below on expiration, the option contract is valued at zero. An in-the-money contract, before expiration, will also have time value included in the premium price. However, because there are a number of finite days until expiration, the time value diminishes from day one.

If premium is diminishing due to time decay on a long option position (call or put), you might exercise your right to the underlying futures contract. Commodity option trading follows American Style trading rules. One can exercise an option any time during trading hours before the contract expiration date. To exercise an option, simply notify your broker of your intention, and shortly thereafter your broker will confirm that the option position converted into a futures position. A call converts into a long futures contract at the strike price, whereas put converts into a short futures contract at the strike price. The initial margin requirement for the underlying futures contract must be available in the trading account. The initial premium paid for the option contract is forfeited. Therefore, to be at least break-even going into a converted futures position, the potential gain in the futures market must at least cover the premium paid. For example, futures must be at least at 1620.0 for an exercised April 2013 Gold 1600 call purchased for $2,000 (1620.0 – 1600.0 x $100). Plus, one must also factor in any potential commission and fees. Obviously, an out-of-the-money option would be a marked-to-market losing futures position. It probably makes more sense to liquidate that position in the option market as opposed to converting to a futures contract due to the loss of premium.

If there is plenty of time until expiration but the option position (call or put) is the deep-in-the-money, you might exercise your right to the underlying futures contract. Deep-in-the-money option contracts will have higher delta. Delta is the value at which the premium price will change (all else being equal) based on the corresponding change of the underlying futures contract. The higher the delta, the more susceptible the premium is to fluctuate as the futures price changes. An option contract with a delta of one has the equivalent movement of the underlying futures contract. Therefore, converting this option contract will eliminate the decaying asset aspect of the option contract.

The soliloquy continues in Hamlet: “Whether ‘tis nobler in the mind to suffer the slings and arrows of outrageous fortune or to take arms against a sea of troubles and by opposing end them?” I interpret this as Shakespeare questioning taking a risk to better one’s position in life. Undoubtedly, there is a risk in exercising an option contract, but by taking into consideration the specifics discussed here, an informed decision can potentially better one’s trading position.

Happy Trading!
Don DeBartolo

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