Investors in stock option contracts have the right to buy or sell underlying stocks (or other assets) at a predetermined price within a certain time period. When an investor decides they want to take action on their right to buy or sell, it’s called exercising. There are a number of ways investors can choose to exercise their options contract, depending on their individual goals and financial situation.
Option contracts are complex investment vehicles. They’re a multi-faceted tool that involves precise timing and are backed by lots of strategizing. While options are not for all investors, if handled by experienced traders, options could add diversity to a well-diversified portfolio.
In this article, we focus on the concept of exercising in options. What does it really mean to “exercise an option?” And how do you do it?
What Does Exercising Mean?
Exercising a stock option means that a trader purchases or sells the underlying stock associated with the options contract at the price set by the contract, which is called the strike price. This price may differ from the current market price of the stock.
Options contracts are valid for a certain amount of time. So if the owner doesn’t exercise their right to buy or sell within that period, the contract expires worthless, and the owner loses the right to buy or sell the underlying security at the strike price.
There is also an upfront fee, called a premium, that gets paid when a trader enters into an options contract. If the trader doesn’t exercise the contract, they forfeit that fee along with any other brokerage fees. Most options contracts never get exercised. Some contracts are sold instead of exercised, because the contract itself has value if it has the potential to be exercised later.
There are two main choices of types of options contracts, call options and put options. Purchasing a call option gives traders the right, but not the obligation, to purchase the underlying security at the strike price. Selling put options gives traders the right to sell the underlying security at the strike price.
Each contract is different, and there are also different types of options. American-style options let traders exercise them prior to the contract’s expiration date, while European-style options can only be exercised after the expiration date.
How Do You Exercise an Option?
Generally, traders have several choices when it comes to exercising their stock options. When a trader is ready to exercise an option, they can let their brokerage firm know. The broker will create an exercise notice to the Options Clearing Corporation (OCC) to let the individual or entity buying or selling the underlying stock know that the trader wants to execute a trade on a particular date. The option seller is required to fulfill the obligations of the contract.
The OCC assigns the exercise notice to one of their clearing members, which tends to be the trader’s brokerage firm. The broker then assigns the option to one of their customers who has written an option contract that they have not yet covered. Depending on the broker, the customer they choose may either be chosen randomly or picked on a first-in-first-out (FIFO) principle .
If a trader thinks a stock will go up in value, they can purchase options at a lower market price, then wait until the market price goes up to exercise the option. Then they purchase at their original lower price and can decide to sell at the new, higher market price. This is one of the benefits of trading stock options. However, traders can’t wait forever, because options contracts do have expiration dates.
It is common for company employees to receive stock options, which give them the right to purchase company stock. They can purchase the stock and then hold onto it if they think it will rise in value. However, it’s important for employees to understand the rights they have with their options. Often, stock shares are vested for a certain amount of time, so an employee has to wait for that time to end before they are allowed to exercise the option.
Sometimes there are fees, commissions, and taxes involved in exercising company stock options. To cover those fees, traders can exercise options, purchase shares of company stock and simultaneously sell some of those shares to cover the expenses.
If a company employee wants to immediately sell their stock options after exercising their right to buy the stock, they can choose to exercise and sell. They will receive the cash amount of the current market value of the stock minus any fees and taxes.
In addition to profiting off of a stock’s price increase, options traders may want to exercise early so that they can earn dividends off of the underlying security. Traders who write call options should be prepared to close out a trade at any time prior to the contract’s expiration date, especially if the contract is in-the-money. If a put option is in the money, most likely the owner will exercise it before it expires.
Advantages and Disadvantages of Exercising an Option
Exercising options presents opportunities to earn a profit, but there also are potential downsides to exercising options.
|Earn dividends from owning the underlying stock.||Fees, taxes, transaction costs potentially could cancel out any profit.|
|Sell the underlying stock for a profit.||Increases chance of risk: margin call, stock’s value could decrease.|
|In general, traders can make a greater profit via closing positions — by buying or selling options rather than exercising them.
One of the few instances where it could be advantageous to exercise a contract is if you’d like to own the stock outright instead of basing a contract on it.
|The one way that exercising a contract could actually make you lose out on money has to do with the complicated price structure of options, which consists of two components: extrinsic (time value) and intrinsic value.
If you own options contracts that are in the money, then the price of those contacts will comprise both extrinsic and intrinsic value. If you sell these options, you’d benefit from both the intrinsic and the extrinsic price components.
But if you exercised them instead, you would only benefit from the intrinsic value. Why?
Extrinsic value serves to compensate the writer (seller) of options contracts for the risk they are taking. Once you exercise an options contract, the contract itself effectively ceases to exist, so that all extrinsic value is lost.
How Do You Know Whether to Hold or Exercise an Option?
It can be difficult to know when and whether to exercise an option. There are different options trading strategies that can prove beneficial to exercising early, or to waiting or even selling the option contract itself. Many factors come into play when making the decision to exercise an option, such as
• the amount of time left in the contract,
• whether it is in-the-money and if so by how much, and
• whether the trader wants to buy, sell, or hold shares of the underlying security.
One key thing to know about options trading is how options pricing works. Options lose value over time until they are finally worth nothing at their expiration date. If a trader owns an option that still has time left on it, they may consider selling the option or waiting to exercise it. Often it is more profitable to sell the option than to exercise it if it still has time value. If an option is in the money and close to expiring, it may be a good idea to exercise it. Options that are out-of-the-money don’t have any intrinsic value, they only have time value.
In addition to the premium a trader pays when buying an option, they must also pay transaction and commission fees to their broker. There can be fees both when exercising an option and when buying or selling the underlying shares.
Increased Chance of Risk
Buying a call option is fairly low risk because the most a trader can lose is the premium amount they paid when they bought into the contract. Exercising an option increases risk, because even if the trader profits in the short term by exercising and buying the stock at a good price, the stock could decrease in value any time. Because the trader already lost the premium amount, they would need to earn at least that amount back to break even on the trade.
Exposure to Margin Risk
To purchase the shares of the underlying security, a trader needs to use cash from their account or take out a margin loan from their broker. If they take out a loan, they increase their chances for risk and greater expenses.
The owner of a long option contract has the right to buy shares of the underlying stock if they choose to exercise it. The selling trader on the other side of the contract is obligated to fulfill the contract if the owner decides to buy. If the buyer exercises their right, the seller must deliver the number of shares — generally 100 shares per contract — for the strike price set by the contract. If the buyer does exercise the contract, they are then obligated to pay the seller for those shares.
The brokerage firm gives notice to a random seller when a buyer exercises an option that fits the transaction parameters. This could happen at any time prior to the expiration date. A seller can close out their option contract early if it hasn’t been exercised yet. The process of assigning and exercising options is all automated. So if a trader sells an option, when it gets exercised the stock will automatically be removed from their account, and they receive cash in their account in return. The buyer will receive the shares in exchange for cash from their brokerage account.
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How can you tell when to exercise an option?
It could be beneficial to exercise an option if the underlying security’s price is more than the strike price of a call option; or the underlying security’s price is less than the strike price of a put option.
How are early-exercise options different from exercise options?
Early-exercise options differ from exercise options in one way: Early exercise is possible with American-style option contracts only. You cannot do this with European-style option contracts, as they rule that you may exercise on the expiration date only.
What is a cashless exercise in options?
Also called the “same-day sale,” a cashless exercise is when an employee exercises their stock options via a short-term loan provided by a brokerage firm.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
*Borrow at 7.00%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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