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Chapter 3. Options in Context > Exercise as a Desirable Outcome

Exercise as a Desirable Outcome

One context of options that is often ignored is the desirability of exercise in some circumstances. Exercise is usually avoided as part of an overall strategic approach based on your wanting to enhance current income while doing all you can to keep well-selected, long-term growth stocks. In the covered call strategy, exercise is most likely when the stock's price is rising, so escaping exercise provides more capital gains in the stock, to be realized later. Avoiding exercise by rolling out of positions is usually a practical method for managing covered call positions; even if exercise does occur in the future, it is preferable at a higher strike price. There are circumstances in which you will welcome exercise:

  1. Writing deep in-the-money calls, even with tax consequences in mind. If you have a substantial carryover loss to bring forward, you are limited to a maximum of $3,000 per year in capital losses you can claim. When your carryover is far above that level, you will not be concerned about the loss of long-term status you suffer when writing deep in-the-money covered calls. In fact, in that situation, your covered-call-writing strategy could be designed to invite exercise. Since deep in-the-money calls consist mostly of intrinsic value, changes in the stock's market value are matched dollar for dollar by changes in the call's premium. Covered calls provide complete downside protection to the extent of intrinsic value in this case; for example, if your covered call contains 20 points of intrinsic value, you receive the entire premium when you write the call; and the price drops for each point loss in the stock or rises with each point gained in the stock. The call can be closed for a purchase price below the original sale level if stock prices drop, so your lost points in the stock can be recovered in the changed option premium. This strategy works only when two conditions are present: (1) you have substantial carryover loss and don't care about losing long-term treatment for covered call transactions, and (2) your basis in the stock is lower than the strike price or lower than the strike price minus call premium. (For example, if you bought stock at $35 per share and it is now worth $60, you may decide to sell a 30 call. That will bring you 30 points of intrinsic value plus whatever time value premium is available. It is entirely possible when stock has appreciated to this extent to receive total call premium that exceeds your basis in the stock. That makes any outcome risk-free; if you can take out not only your basis, but extra profits as well, you have no net capital investment, but you still own long shares against a short call. So, following such a transaction, a decline in the stock price could produce a profit in the call due to changes in intrinsic value.

  2. Selling puts as a form of contingent purchase when the strike price makes sense. If you are willing to buy stock at the short put strike price, minus the premium, then exercise makes sense. For example, stock is currently valued at $33 per share and you can get 4 points for the 30 put. Upon exercise, you would acquire shares at the fixed strike price of $30 per share; your basis would be $26 per share due to the $400 put premium you were paid. The ideal condition is to experience exercise above $26, meaning your net basis would be lower than market value (not counting trading fees).

  3. Accepting exercise when fundamental indicators have changed. You may find yourself in the interesting position of owning stock with a short covered call, to also discover that you no longer want to own the stock. If the call is in the money, you can simply accept exercise in this situation and take your profit. If tax consequences are not important to you (e.g., if you have a large carryover loss), you could also roll down to a lower strike price, gain 5 points in additional profits, and accept the certainty of exercise. If you don't want to wait for the outcome but prefer to exercise more quickly, you can roll down with the same strike price; you can even execute an unusual rollback, replacing the original exercise price with one on an earlier date. Combined with a roll down, this creates net premium income while accepting exercise as an exit strategy on shares of stock. The acceptance of exercise in this case may be more practical than closing a covered option position and perhaps taking a loss on the transaction just so that you would be free to sell shares of stock. As with the case of a deep in-the-money call written originally, this decision could affect the tax status of your stock; it is most practical when you want to absorb a large carryover loss.


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