Skip to main content

This week's Options Forum addresses some typical beginner's questions about when it's best to close out an equity option position.

And remember, we're always open to reader questions, so drop a note to

Options Forum and include your full name.

Close-Out Sale

I am considering investing in options, and I would appreciate it if you could answer one of my questions. The question is: Can you sell, for example, a call option that expires in December before its expiration date if the price of a stock, let's say, is already well above its strike price. Suppose I hold a Corning (GLW) - Get Corning Inc Report December 100 call option. On Nov. 10, Corning is trading at $120 and I want to sell the contract. Can I sell the call on Nov. 10 when the price is high, or do I have to wait until the last day before the option expires? -- Radek Matuk

Radek,

The fine folks at the

Options Industry Council's

call center say: "Under normal circumstances, you, as the options holder, are not prohibited from closing out an option position before the expiration date of the contract."

The OIC says, on average, more than 50% of all expiring option positions are closed out in the marketplace prior to their expiration. In some options circles, this is known as trading premium.

So in your example, an investor could sell back the contracts that he bought and close out the position for a tidy profit well before the option expires, if he so desires.

There are index options that are called European-style expiration, which can't be exercised until expiration. That fact, however, doesn't prohibit them from being traded between market participants before expiration. American-style options -- all single equity options and some index contracts -- can be exercised at any time prior to or at expiration.

Out-of-the-Money Calls

Another reader -- known only as Joe -- is pondering a somewhat similar question, having to do with an out-of-the-money call, one with a strike price higher than the current share price. He paid 3 ($300) for a 75 call option on a stock that is trading at $50 a share. Now he's wondering, if the stock trades up to $60 a share before expiration, can he sell this call for a profit?

The answer, as with so many things in life, is: It depends, says John Power, head of marketing at

BOTTA Trading

TheStreet Recommends

and former

Options Institute

honcho.

First, says Power, if the stock ever traded above $78 a share, your option would be worth (intrinsically) $3 at least. But even if the option does not go

in-the-money before expiration, it could still regain value. How much? Well, that's the $64,000 question.

Options usually trade for a price that can roughly be called "fair value." What is a fair price for an option? Professionals usually use a version of a pricing formula pioneered by professors Fisher Black and Myron Scholes around 1993.

That formula tells an investor that the

theoretical

fair value will depend on six factors: underlying stock price, time to expiration, strike price, dividends the stock pays, prevailing interest rates, i.e., cost of money, and something called

volatility (of the underlying stock).

Any and all of these will affect the theoretical value of any option, to a greater or lesser degree.

(A great place to see how this works is the Chicago Board Options Exchange Web site. It has an option-price calculator that you can experiment with.)

In a very basic sense, Power says, the price will depend on how likely the option is to be in-the-money (in this case, that means the stock will be above $75) before it reaches its expiration date. A very volatile stock increases that likelihood, and a very quiet stock makes that outcome less likely. So, if the stock is usually very quiet and it rises to $60, but there is only one day until expiration, the option will not be worth $3.

If the stock rises to $60, but there is one year until expiration, you might get that price. If the stock rises to $60 and there are six months until expiration, but it's a very volatile stock, you might get even more than your $3 for the option.

So you have to ask yourself, "How likely is it that this stock will get above $75 (its strike price) before expiration?" How other investors answer that question will determine how much they will be willing to pay for your option.