When done correctly, options trading can generate substantial profits. However, it is not the simplest trading method in the world.
If you’re new to options trading and the concept of exercising options, you’ve come to the right place. In this guide, I’ll tell you everything you need to know about exercise options. Continue reading to find out more.
What Are Options?
First and foremost, let me quickly explain what options are. Options are essentially a type of financial derivative contract that is linked to an underlying asset such as stocks, ETFs, indexes, futures, and so on. For the sake of simplicity, I will refer to options on stocks.
This type of contract grants the buyer the right (but not the obligation) to buy or sell the underlying stock at a specific price determined at the time of purchase. This is known as the “strike price,” and it is one of the most important terms to understand when trading options.
Each option contract has an expiration date. Up until the expiration date, the contract owner has the right to exercise their options and buy or sell the stock at the strike price (depending on the type of option contract). There is no obligation to exercise these rights, and knowing when to (and when not to) exercise your options is a critical concept for becoming a successful options trader.
Put Options Vs Call Options
The only two option contracts available are put options and call options.
Put Options
If you purchase a put option, you will have the right to sell shares of the underlying stock at the strike price prior to or on the expiration date. As previously stated, you are not obligated to sell and would only do so if it would generate a profit.
If you exercise your right as the owner of a put option, then the person who sold (or wrote) the contract is obligated to purchase the underlying shares at the agreed strike price. So, while you are not required to exercise your right, the writer of the contract must purchase your shares if you do.
When trading put options, they are in-the-money (ITM) when the underlying stock’s market value is lower than the strike price.
Call Options
Call options, on the other hand, provide the contract holder the right to purchase shares of the underlying company at the strike price before to or on the expiration date. They are essentially the inverse of put options.
The owner of an option call contract, like the owner of a put option, is not obligated to exercise the right, in this case purchasing the shares.
When it comes to call options, they are in-the-money (ITM) when the stock’s market value exceeds the strike price. In this case, you can use the call contract’s right to purchase shares at a lower price (the strike price) than the current stock price on the open market.
What Does it Mean to Exercise an Option?
When you exercise an option as an option buyer (the contract holder), you are simply exercising the right granted by the derivative contract. You will buy or sell the underlying stock according to the contract terms, depending on whether the contract is a call or a put option. As a result, you will either buy or sell shares of the underlying company at the strike price.
To profit from option trading as an option buyer, you must decide whether or not to exercise your right. This decision is primarily influenced by whether the position is in-the-money (ITM) or out-of-the-money (OTM) (OTM). When the position expires in the money, it is usually a good thing for the option buyer.
Let me explain the concept by examining the various scenarios that could occur for both a call and a put option contract.
Call Option Example
Stock with ticker symbol ABC is currently trading at $80 per share on the open market. You purchase a call option with a strike price of $85 that expires in 30 days. As a result, when you open the position, the call option is out-of-the-money (OTM) because the current stock price is lower than the strike price of the option.
You pay a $1.00 premium per share to purchase one call option contract. This contract grants you the right (but not the obligation) to purchase 100 shares of stock ABC at the strike price of $85 before the contract expires.
Scenario 1
Stock ABC is trading at $75 per share at the time of expiration. In this case, there is no reason to exercise the call option contract and buy the shares at the $85 strike price because their value on the open stock market is much lower. You let the option contract expire worthless, and you lose the premium you paid to open the position. The same scenario applies if the stock is trading at any other price lower than the strike price.
Scenario 2
Stock ABC is trading at $85 per share at the time of expiration. If you exercise the option contract, you will end up acquiring shares at the strike price ($85), which is the same price as the stock on the open contract. The premium paid to open the position ($1.00 per share) is lost, resulting in a loss on the trade.
Scenario 3
Stock ABC is trading at $86 per share at the time of expiration. You can buy the shares at $85 and immediately sell them on the open market for $86, making a $1.00 gross profit per share. However, the profit is completely offset by the $1.00 per share cost of purchasing the call contract.
Scenario 4
Stock ABC is trading at $90 per share at the time of expiration. You can buy the shares at the strike price of $85 and immediately sell them on the open market for $90, making a $5.00 gross profit per share. The net profit on the position is $4.00 per share after deducting the premium paid to purchase the call option contract ($1.00 per share).
Put Option Example
Stock with ticker symbol ABC is currently trading at $80 per share on the open market. You purchase a put option with a strike price of $75 that expires in 30 days. As a result, when you open the position, the put option is out-of-the-money (OTM) because the current stock price is higher than the strike price of the option.
You pay a $1.00 premium per share to purchase one put option contract. This contract gives you the right (but not the obligation) to sell 100 shares of stock ABC at the strike price of $85 before the contract expires.
Scenario 1
Stock ABC is trading at $90 per share at the time of expiration. In this case, there is no reason to exercise the put option contract and sell the shares at the $75 strike price because their value on the open stock market is much higher. You let the option contract expire worthless, and you lose the premium you paid to open the position. The same scenario applies if the stock is trading at any other price higher than the strike price.
Scenario 2
Stock ABC is trading at $75 per share at the time of expiration. If you exercise the option contract, you will end up selling shares at the strike price ($75), which is the same price as the stock on the open contract. The premium paid to open the position ($1.00 per share) is lost, resulting in a loss on the trade.
Scenario 3
Stock ABC is trading at $74 per share at the time of expiration. You can short-sell the shares at $85 and immediately buy-back them on the open market for $75, making a $1.00 gross profit per share. However, the profit is completely offset by the $1.00 per share cost of purchasing the put contract.
Scenario 4
Stock ABC is trading at $70 per share at the time of expiration. You can short-sell the shares at the strike price of $75 and immediately buy-back them on the open market for $70, making a $5.00 gross profit per share. The net profit on the position is $4.00 per share after deducting the premium paid to purchase the put option contract ($1.00 per share).
Exercise a Call Option for Dividend Payment
If the underlying stock is due for a dividend payment, it may be a good idea to exercise your call options. In this case, you could exercise your right (before the ex-dividend date) and purchase the stock in order to be eligible for the dividend payment. And after that, you can decide whether to keep the stock or sell it based on market value and your investment strategy.
What If You Don’t Exercise an Option?
When it comes to trading options, the expiration date is one of the most important dates to remember. All option contracts have an expiration date, after which you (as an option buyer) you lose your right to buy (for a call option) or sell (for a put option) the shares at the strike price.
However, if you are an option buyer (holder of the option contract) and your options are in the money when they expire, your broker will automatically exercise your right. A call contract requires you to buy 100 shares of the underlying stock at the strike price, whereas a put contract requires you to sell 100 shares of the underlying stock at the strike price.
Any option contract that expires out-of-the-money, on the other hand, will be worthless and will not be automatically exercised by your broker.
What is the Alternative to Exercise an Option?
Always keep in mind that as the buyer (holder) of an option contract, you have the right but not the obligation to exercise the contract. This means you can avoid the process of purchasing (for a call) or selling (for a put) the stock and then immediately liquidating the position to book a profit.
Let me clarify the concept by returning to the previous examples for both a call and a put option contract.
Call Option Example
On the open market, stock ABC is trading at $80 per share. You buy a call option with a strike price of $85 and an expiration of 30 days. The call option costs $1.00 per share to purchase.
This contract gives you the right (but not the obligation) to buy 100 shares of stock ABC for $85 before the contract expires.
At expiration, the value of the option contract is determined solely by the intrinsic value of the option, as time value has reached zero. The difference between the stock price and the strike price is used to calculate the intrinsic value of an ITM (in-the-money) call option.
So, for example, if stock ABC is trading at $90 per share at the time of expiration:
$90 (stock price at expiration) – $85 (strike price) = $5 (call option price at expiration)
Because you paid $1.00 for the initial call contract, you can now sell it for $5.00 and make a $4.00 profit per share.
Put Option Example
On the open market, stock ABC is trading at $80 per share. You buy a put option with a strike price of $75 and an expiration of 30 days. The call option costs $1.00 per share to purchase.
This contract gives you the right (but not the obligation) to sell 100 shares of stock ABC for $75 before the contract expires.
At expiration, the value of a put option is determined solely by the intrinsic value of the option, as time value has reached zero. The difference between the strike price and the stock price is used to calculate the intrinsic value of an ITM (in-the-money) put option.
So, for example, if stock ABC is trading at $70 per share at the time of expiration:
$75 (strike price) – $70 (stock price at expiration) = $5 (put option price at expiration)
Because you paid $1.00 for the initial put contract, you can now sell it for $5.00 and make a $4.00 profit per share.
Summary
In this article, I discussed the critical concept of option exercise, using examples from both call and put contracts.
Education is the key to success in options trading, just as it is in any other field. Understanding the main concepts (such as options exercising) and how they apply in different situations will help you make better and more informed trading decisions.