Do investors go long option contracts when they cannot cover the exercise of the options?

Question

Consider I want to buy some american-style call options for a particular stock, and suppose this underlying stock 'XYZ' is valued at $100 a share.

Suppose I go long (buy) 10 option contracts for XYZ at a $100 strike, and the option itself is currently valued at $2.00

I'll spend $2,000 on the option contracts. The total value of the underlying stock 'XYZ' represented by contracts is $100,000.

Suppose I am willing to risk all $2,000 for the options contracts, but cannot get into a situation where I need to pay $100,000 to the broker, which would be outside my available margin/portfolio value.

Given this the above:

1. Since I'm long the call options, I won't risk assignment. But I must avoid the options being exercised to avoid having to buy the underlying. If I do not exercise, I think the options can only be exercised if the options expire in-the-money. If I make sure to sell back the contracts before expiration, I can avoid buying the underlying. Or they can expire worthless. Is there a situation where I will not be able to sell back the contracts and be forced to buy the stock at the underlying value?
2. Will the broker balk at practices like this?
3. Is this a common situation that is practiced by individual investors, or do they always make sure they have enough available margin to cover their options if it they are excercised, even if they always long the option?

Answer 1

I think it depends on your broker. Some brokers will not try to auto exercise in the money options. Others will try to do the exercise it if you have available funds. Your best bet, if find yourself in that situation, is to sell the option on the open market the day of or slightly before expiration. Put it on your calendar and don't forget, you could loose your profits.

@#2 Its in the best interest of your broker to exercise because they get a commission. I think they are used to this situation where there is a lack of funds. Its not like bouncing a check. You will need to check with your broker on this.

@#3 I think many or most options traders never intend on buying the underling stock. Therefore no, they do not always make sure there is enough funds to buy.

Answer 2

I do this often and have never had a problem. My broker is TD Ameritrade and they sent several emails (and even called and left a message) the week of expiry to remind me I had in the money options that would be expiring soon.

Their policy is to automatically exercise all options that are at least $.01 in the money. One email was vaguely worded, but it implied that they could liquidate other positions to raise money to exercise the options. I would have called to clarify but I had no intention of exercising and knew I would sell them before expiry.

In general though, much like with margin calls, you should avoid being in the position where the broker needs to (or can do) anything with your account.

As a quick aside: I can't think of a scenario where you wouldn't be able to sell your options, but you probably are aware of the huge spreads that exist for many illiquid options. You'll be able to sell them, but if you're desperate, you may have to sell at the bid price, which can be significantly (25%?) lower than the ask. I've found this to be common for options of even very liquid underlyings. So personally, I find myself adjusting my limit price quite often near expiry. If the quote is, say, 3.00-3.60, I'll try to sell with a limit of 3.40, and hope someone takes my offer. If the price is not moving up and nobody is biting, move down to 3.30, 3.20, etc.

In general you should definitely talk to your broker, like others have suggested. You may be able to request that they sell the options and not attempt to exercise them at the expense of other positions you have.