Mastering Derivatives: ITM call: Right to buy?

A European call option is defined as a “right but not an obligation” to buy an underlying at a pre-determined price on the expiry of the contract. Market regulations can, however, affect the characteristics of an option. This week, we discuss why it is moot if you say you have the “right but not an obligation” to buy the underlying when you hold an in-the-money (ITM) call option at contract expiry. 

Exercise or close 

Most option traders close their long positions before expiry. This is because option traders are typically uninterested in exercising a call option and taking delivery of the underlying or in exercising a put option and giving delivery of the underlying at expiry. Instead, the objective of going long on a call option is to bet on the underlying moving up so that the call can be sold at a higher price. Likewise, the objective of going long on a put option is to bet on the underlying going down so that the put can be sold at a higher price. 

The issue is that the exchange cannot function on the premise that you will close your ITM option before expiry. It will assume that you will exercise the option if your ITM position is open during the expiry week. That means you must have the capital in your trading account to take delivery of the underlying at expiry of the call option; the capital required equals the strike price times the permitted lot size plus transaction costs. To ensure that you will have enough money at expiry to take delivery of the shares, your broker will increase the margin requirement on your ITM call as the option approaches expiry. 

Now, suppose you do not close your long call position and the option expires ITM. You are required to take delivery of the underlying. You do not have a choice. The regulation requires that all open ITM calls must result in the long position taking delivery. The Do Not Exercise (DNE) facility that NSE offered earlier was withdrawn this March.

You may wonder as to who would want to carry ITM call position to expiry. Sometimes, an out-of-the-money (OTM) call can become ITM because of a sharp surge in the underlying price during the expiry week. If you do not close the position immediately, a continual increase in the underlying price will lead to the call losing its liquidity; for call strikes become less liquidity the more intrinsic value they carry. You may, hence, unintentionally carry the ITM position till expiry.

Know this

Sometimes, an out-of-the-money (OTM) call can become ITM because of a sharp surge in the underlying price during the expiry week.

Optional reading

You could trade index options if you do not want to risk holding an ITM option that will require you to take delivery at contract expiry; for index options are cash settled. As for equity options, given the increase in margin requirement as the option approaches expiry, it will be optimal to close your long position by Friday preceding the expiry week.

The author offers training programmes for individuals to manage their personal investments

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