Exercise an option: Meaning, Criticisms & Real-World Uses

What Is Exercise an Option?

To exercise an option contract means to put into effect the right granted by the contract to either buy or sell the underlying asset. This action falls under the broader category of derivatives and options trading. When an investor decides to exercise an option, they are initiating the transaction to acquire shares (for a call option) or sell shares (for a put option) at the predetermined strike price specified in the agreement. The decision to exercise an option is typically made when the option is "in-the-money," meaning it holds intrinsic value, making it profitable to convert into the underlying shares.

History and Origin

The concept of options has roots in ancient times, with references dating back to Greek philosopher Aristotle, who described Thales of Miletus speculating on an olive harvest. However, the modern, standardized exchange-traded options market is a much more recent development. Prior to the 1970s, options were primarily traded "over-the-counter" (OTC), requiring direct negotiation between buyers and sellers, which often led to complex terms and limited liquidity. The landscape of options trading was revolutionized with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked the first time that option contracts were standardized, making them easier to trade and understand for a wider audience. The creation of the CBOE, along with the establishment of the Options Clearing Corporation (OCC) for centralized clearing, provided a fair marketplace and ensured the proper fulfillment of contracts, boosting investor confidence and legitimizing options trading.³

Key Takeaways

Exercising an option converts an option contract into the underlying shares (for calls) or enables the sale of shares (for puts) at the specified strike price.
The decision to exercise an option is usually made when the option is in-the-money, providing a favorable price relative to the current market price of the underlying asset.
For American-style options, exercise can occur any time up to the expiration date; for European-style options, it can only occur at expiration.
Exercising an option requires the holder to have sufficient capital (for calls) or the underlying shares (for puts) to fulfill the transaction.
Upon exercise, the option holder takes on the rights and responsibilities of owning or shorting the underlying asset.

Interpreting the Exercise of an Option

The act of exercising an option signifies the holder's intent to convert their contractual right into a tangible position in the underlying asset. When an investor chooses to exercise a call option, they are buying the underlying shares at the strike price. This is advantageous if the market price of the shares is higher than the strike price, as they acquire the shares at a discount. Conversely, exercising a put option means selling the underlying shares at the strike price. This is beneficial if the market price is lower than the strike price, allowing them to sell shares for more than their current market value.

The timing of the decision to exercise an option is crucial and depends on the option's style. American-style options permit exercise at any point before or on their expiration date. In contrast, European-style options can only be exercised on their expiration date. Most individual investors, and even many institutional traders, often choose to sell their option contracts in the open market rather than exercising them, as selling can sometimes yield a higher profit by capturing the remaining time value of the option. However, exercising is necessary when the goal is to take direct ownership of the shares or to close out a specific position.

Hypothetical Example

Consider an investor, Sarah, who believes that Company XYZ's stock, currently trading at $55 per share, will increase significantly. She decides to buy a call option with a strike price of $50 and an expiration date three months away. She pays a premium of $6 per share for this option. Each contract represents 100 shares.

A month later, Company XYZ's stock price soars to $60 per share due to a positive earnings report. Sarah's call option is now significantly in-the-money.

Sarah has two main choices:

Sell the option: She could sell her call option on the market. With the stock at $60 and a strike of $50, the option has at least $10 of intrinsic value. Assuming some time value remains, she might sell the option for, say, $11 per share. Her profit would be ($$11 - $6 = $5) per share, or $500 per contract.
Exercise the option: Sarah decides she wants to own the shares of Company XYZ. She instructs her broker to exercise the option. Upon exercise, she pays the strike price of $50 per share for 100 shares, costing her $5,000. She now owns 100 shares of Company XYZ that are currently worth $60 per share in the market. Her total cost for owning the shares, including the premium paid for the option, is ($$50 \text{ (strike)} + $6 \text{ (premium)} = $56) per share. Since the market price is $60, she has an immediate unrealized gain of $4 per share, or $400 for the 100 shares.

Practical Applications

Exercising an option is a fundamental action within options trading and has several practical applications for investors and institutions alike. For individual investors, exercising a call option allows them to acquire shares of a company at a price lower than the current market value, which can be part of a long-term investment strategy to build a position in a desirable stock. Conversely, exercising a put option allows them to sell shares at a higher price than the current market, effectively limiting potential losses on existing stock holdings or profiting from a decline in price.

Beyond individual speculation, institutions frequently use options for sophisticated hedging strategies. For example, a large fund might exercise put options to protect a substantial stock portfolio against a market downturn, ensuring they can sell their shares at a predetermined price. Institutional options hedging can involve complex strategies to manage exposure to market volatility or specific asset classes.² The ability to exercise specific option contracts as needed is crucial for these complex risk management frameworks. Derivatives, including options and futures contracts, are also integral to arbitrage strategies, where traders seek to profit from temporary price discrepancies between different markets by simultaneously buying and selling related assets, sometimes involving the exercise of options to capture these differences.

Limitations and Criticisms

While exercising an option provides a direct means of acquiring or disposing of an underlying asset at a fixed price, it also comes with limitations and potential criticisms. One significant drawback is that exercising a profitable option contract may mean forgoing additional profit that could have been realized by selling the option on the open market. Options often trade with "time value" in addition to their intrinsic value, especially if there is still significant time until the expiration date. By exercising, the holder gives up this remaining time value.

Furthermore, exercising a call option requires the investor to have sufficient capital to purchase the shares, and exercising a put option requires ownership of the shares to sell. If an investor does not have the necessary funds or shares, they cannot exercise and must either sell the option or let it expire.

A broader criticism, particularly concerning retail investors, is the inherent complexity and risk associated with options trading. Research indicates that many retail investors can incur significant losses when trading options, often due to a lack of understanding of sophisticated strategies or the rapid decay of options' value.¹ The regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), oversee the options market to ensure fairness and transparency, yet the complexity necessitates robust risk management on the part of individual traders.

Exercise an Option vs. Lapse an Option

The primary distinction between exercising an option and letting an option lapse lies in the action taken by the option holder concerning their option contract.

Exercise an Option: When an investor decides to exercise an option, they are actively putting their contractual right into effect. For a call option, this means buying the underlying asset at the strike price. For a put option, it means selling the underlying asset at the strike price. This action is typically taken when the option is in-the-money and profitable, allowing the holder to realize the intrinsic value of the contract.

Lapse an Option: To lapse an option, also known as letting an option expire worthless, means the option holder takes no action to exercise their right, and the option contract becomes invalid on its expiration date. This occurs when an option is out-of-the-money (not profitable to exercise) or when the holder simply chooses not to exercise, perhaps because they sold the option before expiration or because they do not wish to take on the underlying position. When an option lapses, the holder loses the entire premium paid for the option.

FAQs

When should I exercise an option?

You should consider exercising an option only if it is in-the-money and you wish to take physical delivery of the underlying asset (for a call option) or dispose of the underlying asset (for a put option). For American-style options, you can exercise any time before the expiration date. For European-style options, you can only exercise on the expiration date. In many cases, it may be more financially advantageous to sell your option contract in the open market rather than exercising, as selling can capture any remaining time value.

Do all options get exercised?

No, not all options get exercised. Many options expire worthless if they are out-of-the-money at their expiration date. Additionally, even options that are in-the-money may not be exercised if the holder chooses to sell the option contract in the open market to realize a profit, rather than taking physical delivery of the underlying shares.

How do I exercise an option?

To exercise an option, you typically notify your brokerage firm of your intention. Most brokers offer an online interface or require a phone call to initiate the exercise process. Ensure you have the necessary funds to purchase shares if exercising a call option, or the shares themselves if exercising a put option. The Options Clearing Corporation (OCC) then facilitates the transaction between the exercising party and the assigned option writer.