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Exercise option

What Is Exercise Option?

Exercising an option refers to the act of invoking the right, but not the obligation, granted by an option contract to buy or sell the underlying asset at a predetermined strike price. This action is a crucial stage within the lifecycle of derivatives and the broader field of options trading. When an investor exercises an option, they are effectively converting the contractual right into a transaction involving the actual underlying security or commodity.

History and Origin

The concept of options has roots dating back to ancient Greece, with the philosopher Thales of Miletus said to have profited from predicting an olive harvest and securing rights to olive presses. However, the modern, standardized options market, as recognized today, began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This development revolutionized options trading by providing a regulated, centralized marketplace, standardizing contract terms, and introducing formal market makers to provide continuous trading interest. This brought greater transparency and efficiency to a market previously dominated by unstandardized, over-the-counter (OTC) agreements.7

Key Takeaways

  • Exercising an option converts the contractual right into ownership or sale of the underlying asset.
  • For a call option, exercising means buying the underlying asset at the strike price. For a put option, it means selling the underlying asset at the strike price.
  • Options are typically exercised when they are in-the-money, meaning profitable to do so.
  • Most options are closed out before expiration rather than exercised, as this avoids the need to take delivery of or deliver the underlying asset.
  • Automatic exercise rules typically apply to in-the-money options at expiration, though investors can choose to override this.

Formula and Calculation

While there isn't a direct "formula" for exercising an option itself, the decision to exercise is driven by the intrinsic value of the option, which can be calculated as follows:

For a Call Option:
Intrinsic Value=max⁡(0,Current Underlying Price−Strike Price)\text{Intrinsic Value} = \max(0, \text{Current Underlying Price} - \text{Strike Price})

For a Put Option:
Intrinsic Value=max⁡(0,Strike Price−Current Underlying Price)\text{Intrinsic Value} = \max(0, \text{Strike Price} - \text{Current Underlying Price})

An option's total value is composed of its intrinsic value and its time value. The premium an investor pays for an option reflects both these components. When exercising, only the intrinsic value is realized, as the time value effectively becomes zero.

Interpreting the Exercise Option

Interpreting the exercise of an option primarily involves assessing whether it is financially advantageous. An investor holding a call option will typically only exercise if the current market price of the underlying asset is above the strike price, making the option in-the-money. Conversely, a holder of a put option would only exercise if the underlying asset's price is below the strike price.

The decision to exercise can also be influenced by factors like dividends on stocks or the desire to take immediate ownership or short an asset. However, for most retail investors, it is often more capital-efficient to sell an in-the-money option in the market rather than exercise it, as selling allows the investor to capture both the intrinsic and remaining time value, whereas exercising only captures the intrinsic value.

Hypothetical Example

Consider an investor, Sarah, who buys a call option on ABC Corp. with a strike price of $50 and an expiration date three months away. The option cost her a premium of $3 per share. Each option contract typically represents 100 shares.

Suppose the share price of ABC Corp. rises to $55 before the expiration date. Sarah's call option is now in-the-money.
If Sarah decides to exercise her option, she would pay $50 per share to acquire 100 shares of ABC Corp. for a total of $5,000. She could then immediately sell these shares in the open market at the current price of $55 per share, receiving $5,500.

Her profit from exercising would be:
Profit=(Selling Price−Strike Price)×Number of Shares−Premium Paid\text{Profit} = (\text{Selling Price} - \text{Strike Price}) \times \text{Number of Shares} - \text{Premium Paid}
Profit=($55−$50)×100−($3×100)\text{Profit} = (\$55 - \$50) \times 100 - (\$3 \times 100)
Profit=($5×100)−$300\text{Profit} = (\$5 \times 100) - \$300
Profit=$500−$300=$200\text{Profit} = \$500 - \$300 = \$200

Alternatively, Sarah could sell her option contract on the open market and likely realize a similar or greater profit, as the option's market value would reflect its intrinsic value plus any remaining time value.

Practical Applications

The exercise of options plays a fundamental role in several areas of finance:

  • Employee Stock Options (ESOs): Many companies grant ESOs to employees, giving them the right to purchase company stock at a predetermined price. Employees "exercise" these options to acquire shares, often when the stock price has risen significantly above the grant price.
  • Arbitrage Opportunities: Sophisticated traders may exercise options as part of arbitrage strategies, seeking to profit from minor price discrepancies between the option and its underlying asset across different markets.
  • Dividend Capture: In some cases, investors might exercise a call option just before the ex-dividend date of a stock to become a shareholder of record and receive an upcoming dividend. This is a complex strategy and carries risks.
  • Strategic Portfolio Management: Large institutional investors or portfolio managers might exercise options to gain immediate exposure to, or divest from, an underlying asset, especially when swift action is required or specific tax implications are at play. Options trading itself is facilitated by brokerage firms, which provide platforms and the necessary liquidity for these transactions.

A notable instance where options exercise was a major factor was the GameStop trading frenzy in early 2021. The surge in buying of in-the-money call options by retail investors led to increased hedging by market makers who had sold these options. As market makers bought the underlying stock to cover their exposure, it created a feedback loop, driving the stock price even higher and exacerbating a "short squeeze" phenomenon.5, 6

Limitations and Criticisms

While exercising an option offers a direct way to convert a contractual right into asset ownership or sale, it comes with limitations and potential drawbacks:

  • Loss of Time Value: The primary criticism of exercising an option prematurely (before its expiration date) is the forfeiture of any remaining time value. The option's premium includes both intrinsic value and time value; by exercising, an investor immediately loses the time value component, which could have been captured by selling the option on the open market.
  • Capital Requirements: Exercising an in-the-money call option requires the investor to have sufficient capital to purchase the underlying shares. For example, exercising a call for 100 shares at a $100 strike price requires $10,000. If the investor lacks the funds or margin, they cannot exercise. Similarly, exercising a put option requires the investor to possess the underlying shares to deliver them.
  • Complications for Uncovered Positions: For option writers (sellers), their obligations vary based on whether their position is covered or uncovered. If an investor has written a short position (sold an option) and is assigned, they are obligated to fulfill the contract, which could mean buying or selling the underlying asset at a disadvantageous price.
  • Risk of Price Action: If an investor exercises a call option but the underlying stock experiences a sudden price drop before they can sell the acquired shares, the profit margin could diminish or turn into a loss.

Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) provide investor bulletins and rules to educate investors about the complexities and risks associated with options trading, including exercise.43

Exercise Option vs. Options Assignment

The terms "exercise option" and "options assignment" are closely related but refer to different sides of the same transaction within the options market.

Exercise option describes the action taken by the option holder (the buyer). When an investor exercises a call option, they choose to buy the underlying asset at the strike price. When they exercise a put option, they choose to sell the underlying asset at the strike price. This is an active decision on the part of the holder, though often automated for in-the-money options at expiration.

Options assignment, on the other hand, refers to the obligation placed upon the option writer (the seller) when an option they have sold is exercised by its holder. If an investor has a short position in a call option and it is assigned, they are obligated to sell the underlying asset at the strike price. If they have a short position in a put option and it is assigned, they are obligated to buy the underlying asset at the strike price. The Options Clearing Corporation (OCC) assigns exercise notices to writers of options on a random basis or another fair method. This means that a writer with a long position may be assigned even if there are other, more "out-of-the-money" options outstanding.

The key distinction lies in who initiates the action: the holder exercises, and the writer is assigned.2

FAQs

When should I exercise an option?

Generally, options are exercised when they are in-the-money and when the goal is to acquire or dispose of the underlying asset. For most investors, it's often more beneficial to sell an in-the-money option in the open market to capture both its intrinsic and time value, rather than exercising and forfeiting the time value.

Can an option be exercised before its expiration date?

Yes, American-style options can be exercised at any time up to and including their expiration date. European-style options, however, can only be exercised on their expiration date. Most equity options in the U.S. are American-style.

What happens if I don't exercise an in-the-money option?

If an American-style option is in-the-money at expiration and you take no action, your brokerage firm will typically automatically exercise it on your behalf. This is known as "auto-exercise." However, you should always be aware of your positions and communicate with your broker if you wish to override this default action.

What is the Federal Reserve's impact on options trading?

The Federal Reserve, through its monetary policy decisions, such as setting interest rates, indirectly influences the value of options. Changes in interest rates can affect the cost of borrowing and the overall market sentiment, which in turn impacts the pricing models for options, particularly the time value and the implied volatility of the underlying asset. For instance, higher interest rates can make call options more expensive and put options less expensive, all else being equal.1