Exercise

What Is Exercise?

In finance, "exercise" refers to the act of putting into effect the right granted by an option contract. When an option holder exercises their option, they are enforcing their right to buy or sell the underlying asset at the predetermined strike price before or at its expiration. This action is a core component of derivatives trading within the broader category of investment strategies.

History and Origin

The concept of options, and therefore exercising them, dates back centuries. Early forms of options were often unlisted, bilaterally negotiated products. However, the modern era of standardized, exchange-traded options began in the United States with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. The CBOE introduced the first U.S. listed options market, providing standardized terms, centralized liquidity, and a dedicated clearing entity. On its opening day, April 26, 1973, the CBOE listed options on 16 underlying stocks, trading 911 contracts. This innovation made exercising options a more accessible and regulated process for investors.¹¹,¹⁰,⁹

Key Takeaways

• Exercise is the act of activating the rights granted by an option contract.
• For a call option, exercising means buying the underlying asset at the strike price.
• For a put option, exercising means selling the underlying asset at the strike price.
• The decision to exercise typically depends on whether the option is "in-the-money."
• Option holders can generally exercise American-style options at any time before expiration, while European-style options can only be exercised at expiration.

Formula and Calculation

The decision to exercise an option is not typically based on a complex formula but rather a comparison of the underlying asset's price to the option's strike price.

For a call option, exercise is generally considered when:
[ \text{Current Underlying Price} > \text{Strike Price} ]

For a put option, exercise is generally considered when:
[ \text{Current Underlying Price} < \text{Strike Price} ]

The profit or loss from exercising an option, excluding premiums and commissions, can be calculated as follows:

For a call option:
[ \text{Profit/Loss} = (\text{Current Underlying Price} - \text{Strike Price}) \times \text{Number of Shares per Contract} ]

For a put option:
[ \text{Profit/Loss} = (\text{Strike Price} - \text{Current Underlying Price}) \times \text{Number of Shares per Contract} ]

Most equity options represent 100 shares of the underlying asset.

Interpreting the Exercise

Interpreting the exercise of an option is straightforward: it signifies that the option holder has chosen to take advantage of the favorable price difference between the market price of the underlying asset and the option's strike price. If an investor exercises a call option, they believe the underlying asset's price is likely to remain above the strike price, making it profitable to buy the shares at the lower, locked-in price. Conversely, exercising a put option indicates a belief that selling the asset at the higher strike price is advantageous compared to its current market value. The act of exercise effectively converts the contractual right into an actual position in the underlying security.

Hypothetical Example

Consider an investor, Sarah, who owns one call option for XYZ stock with a strike price of $50 and an expiration date in three months. Each option contract represents 100 shares. The premium Sarah paid for this option was $2 per share, or $200 total for the contract.

Suppose XYZ stock is currently trading at $55 per share. Sarah's option is "in-the-money" because the market price ($55) is greater than the strike price ($50). If Sarah decides to exercise her option, she will buy 100 shares of XYZ stock for $50 per share, totaling $5,000. Immediately after exercising, she could theoretically sell those shares in the open market for $55 per share, netting $5,500.

Her gross profit from the stock transaction would be $5,500 - $5,000 = $500. After accounting for the initial premium paid ($200), her net profit would be $500 - $200 = $300. This example illustrates how exercising a call option allows an investor to purchase an asset at a price below its current market value.

Practical Applications

Exercising options is a fundamental aspect of options trading with several practical applications in financial markets and risk management.

• Acquiring or Disposing of Shares: The most direct application is to acquire shares (via a call option) or dispose of shares (via a put option) at a specific price. This can be used by investors who want to buy or sell stock at a predetermined price regardless of its future market movement.
• Hedging Strategies: Companies and investors use options to hedge against adverse price movements in underlying assets, such as commodities or currencies. For instance, an importer might buy call options on a foreign currency to cap their costs, exercising if the currency strengthens beyond a certain point. Conversely, an exporter might buy put options to protect against a weakening foreign currency. Research from the Federal Reserve has explored how hedging with derivatives, including options, is a widely cited reason for non-financial corporations to manage risk.⁸,⁷,⁶
• Arbitrage Opportunities: Sophisticated traders might exercise options to capitalize on slight price discrepancies between the option's value and the underlying asset's price, often as part of a larger arbitrage strategy.

Limitations and Criticisms

While exercising options provides unique opportunities, it also comes with limitations and criticisms, particularly regarding investor suitability and complexity.

• Complexity and Risk: Options are complex financial instruments, and their trading can be risky. The Financial Industry Regulatory Authority (FINRA) emphasizes that buying and selling options can be risky and requires specific approval from a brokerage firm, noting that options are complicated and some strategies involve substantial risk.⁵,⁴,³ FINRA also issues regulatory notices reminding firms about the due diligence required when approving customers for options trading, given the high risks involved.²,¹
• Forfeiture of Time Value: Exercising an American-style option before its expiration date means forfeiting any remaining time value. An option's premium consists of intrinsic value and time value. If an option is exercised early, the time value, which represents the potential for the option to become more profitable before expiration, is lost. This is a significant consideration, as holding the option might allow for greater profit if the underlying asset moves further in the favorable direction.
• Commissions and Fees: Exercising options typically incurs commissions and fees, which can eat into potential profits, especially for smaller positions.
• Assignment Risk (for sellers): For the seller (writer) of an option, the exercise by the buyer results in "assignment." This obligates the seller to fulfill the terms of the contract, either by selling the underlying asset (for a call writer) or buying it (for a put writer). This can lead to unexpected obligations and potential losses if not properly managed.

Exercise vs. Assignment

The terms "exercise" and "assignment" are intrinsically linked but refer to different sides of an options contract. "Exercise" is the action taken by the holder (buyer) of an option to invoke their right to buy or sell the underlying asset. For example, a call option buyer exercises their right to purchase shares at the strike price.

Conversely, "assignment" is the obligation placed upon the writer (seller) of an option when the option holder decides to exercise. When a call option holder exercises, the call option writer is assigned the obligation to sell the underlying shares at the strike price. Similarly, when a put option holder exercises, the put option writer is assigned the obligation to buy the underlying shares. Understanding this distinction is crucial for both sides of an options trade.

FAQs

When should an investor exercise an option?

An investor typically exercises an option when it is "in-the-money," meaning the current market price of the underlying asset is favorable compared to the option's strike price. For a call, this means the market price is above the strike, and for a put, it means the market price is below the strike. However, for American-style options, deciding whether to exercise early or sell the option (to capture remaining extrinsic value) depends on various factors, including dividends, interest rates, and the option's remaining time until expiration.

What is the difference between exercising a call option and a put option?

Exercising a call option gives the holder the right to buy the underlying asset at the strike price. Exercising a put option gives the holder the right to sell the underlying asset at the strike price.

Are all options exercised?

No, not all options are exercised. Many options expire worthless if they are out-of-the-money at expiration. Additionally, investors may choose to sell their in-the-money options before expiration to realize a profit and avoid the commissions and the commitment of capital required for exercising, especially if there is still significant time value remaining.

What happens if I don't exercise an option?

If you do not exercise an option by its expiration date, and you have not sold or closed the position, the option will expire worthless. You will lose the premium you paid for the option. This is a common outcome for out-of-the-money options.

Can an option be automatically exercised?

Yes, many brokerage firms offer "automatic exercise" for in-the-money options at expiration, often referred to as "exercise by exception." This means if your option is in-the-money by a certain threshold at expiration, your broker will automatically exercise it on your behalf unless you give them instructions to the contrary. Investors should always be aware of their brokerage's policies regarding automatic exercise.