What Is Exercised Option?
An exercised option refers to the act by which the holder of an option contract chooses to invoke their right to buy or sell the underlying asset as stipulated in the contract. This action is a fundamental aspect of options trading, a segment of the broader financial category of derivatives. When an option is exercised, the contractual agreement is fulfilled, and the holder either acquires or sells the specified quantity of the underlying security at the predetermined strike price. The decision to exercise an option depends on whether it is financially advantageous for the holder to do so, typically when the option is in-the-money.
History and Origin
The concept of financial contracts similar to options dates back centuries. One of the earliest accounts is attributed to the ancient Greek philosopher Thales of Miletus, who, predicting a strong olive harvest, reportedly paid a deposit to secure the rights to olive presses, effectively creating a rudimentary call option. Later, in the 17th century, Dutch merchants traded instruments known as "opsies" on the Amsterdam stock exchange, which were described in detail by Joseph de la Vega in his 1688 work "Confusion de Confusiones."4
The modern, standardized options market, however, is much more recent. A pivotal moment occurred with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked the introduction of standardized [option contract]s and a regulated marketplace, significantly enhancing transparency and liquidity in what had previously been an over-the-counter (OTC) market. Concurrently, the Options Clearing Corporation (OCC) was established, serving as the guarantor for all listed options contracts and ensuring their proper fulfillment upon exercise or assignment.3
Key Takeaways
- An exercised option means the holder is acting on their right to buy or sell the underlying asset.
- 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 an option is usually made when the option is in-the-money, meaning it holds intrinsic value.
- Upon exercising, the option contract is fulfilled, and the holder takes possession of or delivers the underlying asset.
Formula and Calculation
While there isn't a direct "formula" for exercising an option, the decision to exercise is based on the relationship between the underlying asset's market price and the option's strike price.
For a Call Option:
A call option holder will typically exercise if the market price of the underlying asset is higher than the strike price. The profit (before commissions and fees) from exercising a call option and immediately selling the acquired shares is:
For a Put Option:
A put option holder will typically exercise if the market price of the underlying asset is lower than the strike price. The profit (before commissions and fees) from exercising a put option and immediately selling the shares acquired at the strike price is:
In both cases, the premium paid for the option reduces the net profit.
Interpreting the Exercised Option
An exercised option signifies that the holder believes it is more financially advantageous to take ownership of (or deliver) the underlying asset than to simply sell the option itself in the open market. This decision is often made when an option is deep in-the-money and near its expiration date, or if the holder wishes to acquire or divest the underlying asset directly. For instance, an investor might exercise a call option to acquire shares at a discount to the current market price, potentially to hold them for long-term investment or to fulfill a short position. Conversely, exercising a put option allows an investor to sell shares at a higher-than-market price, which can be useful for protecting existing holdings.
It is important to note that many options holders choose to sell their options contracts before expiration rather than exercising them, particularly to capture any remaining time value in the option's premium.
Hypothetical Example
Consider an investor, Sarah, who holds a call option for XYZ Company stock. The option has a strike price of $50 and represents 100 shares of XYZ. Sarah purchased this option for a premium of $3 per share, or $300 for the entire contract.
A few weeks later, the market price of XYZ stock rises to $55 per share. Sarah decides to exercise her option.
- Notification: Sarah instructs her brokerage account to exercise the call option.
- Execution: Her broker facilitates the purchase of 100 shares of XYZ stock for her at the strike price of $50 per share, totaling $5,000.
- Outcome: Sarah now owns 100 shares of XYZ stock, which are currently trading at $55 per share. If she were to immediately sell these shares in the market, she would receive $5,500.
- Profit Calculation: Her gross profit from the trade is $5,500 (sale price) - $5,000 (purchase price) = $500. After deducting the initial premium of $300, her net profit is $200 (before commissions).
This example illustrates how an exercised option allows the holder to benefit directly from the movement of the underlying asset.
Practical Applications
Exercised options play a crucial role in various financial strategies:
- Acquisition/Divestiture of Shares: Investors may exercise options to directly acquire shares at a favorable price (calls) or sell shares at a guaranteed price (puts), rather than transacting on the open market. This is particularly common with employee stock options.
- Hedging: Exercising options can be part of a hedging strategy. For example, a put option holder may exercise to sell shares at a predefined price, protecting against a significant decline in the market value of their existing stock holdings.
- Employee Stock Options: Many companies grant employees stock options as a form of compensation. Exercising these options allows employees to purchase company shares, often at a discounted price, which can then be held or sold. The tax implications of exercising employee stock options can be complex and vary based on the type of option and holding period.
- Arbitrage: In rare instances, discrepancies between an option's price and its intrinsic value might create an arbitrage opportunity, leading to an immediate exercise.
- Regulatory Framework: The process of exercising options in regulated markets involves the Options Clearing Corporation, which standardizes the exercise and assignment process, ensuring the integrity of the market.2 For a general overview of options, investors can refer to resources provided by the U.S. Securities and Exchange Commission.
Limitations and Criticisms
While exercising an option provides direct control over the underlying asset, it's not always the most efficient or profitable action. A primary criticism is that exercising an option typically causes the holder to forfeit the option's remaining time value. The premium of an option includes both intrinsic value (the in-the-money amount) and extrinsic value (time value and implied volatility). By exercising, an investor gains the intrinsic value but loses any extrinsic value that the option still holds, which could have been realized by selling the option in the market.
Furthermore, exercising an option requires the holder to have the capital necessary to purchase the underlying asset (for a call) or to deliver the asset (for a put). This can involve significant capital outlay, especially for large positions. Transaction costs, such as commissions, are also incurred when exercising and subsequently selling the acquired shares. Tax implications can also be a significant consideration; depending on the type of option and holding period, gains from an exercised option can be subject to ordinary income tax or capital gains tax. The Internal Revenue Service (IRS) provides detailed guidance on the tax treatment of stock options.1
Exercised Option vs. Option Expiration
The terms "exercised option" and "option expiration" are closely related but refer to distinct events in options trading.
An exercised option describes the active decision by the option holder to convert their contractual right into ownership or sale of the underlying asset at the strike price. This action can occur at any time up to the expiration date for American-style options, or only on the expiration date for European-style options. It is a proactive step taken by the investor.
Option expiration, on the other hand, is the specific date and time at which an option contract ceases to be valid. If an option is not exercised or sold by its expiration date, and if it is out-of-the-money, it simply becomes worthless. For options that are in-the-money at expiration, many brokerage firms will automatically exercise them on behalf of the holder, unless instructed otherwise.
In essence, exercising an option is a choice made before or at the expiration date, while expiration is the final point at which an option's validity ends.
FAQs
What does it mean when an option is exercised?
When an option is exercised, it means the holder has decided to use their contractual right to buy or sell the underlying asset at the specified strike price. For a call option, they buy the shares; for a put option, they sell the shares.
Why would someone exercise an option instead of selling it?
An investor might exercise an option if they want to take physical possession of the underlying asset (for a call) or deliver it (for a put). This could be for long-term investment, hedging purposes, or to cover a short position. However, selling the option itself often allows the investor to capture any remaining time value in the premium, which is forfeited upon exercise.
Are all options exercised?
No, far from it. Many options expire worthless because the underlying asset does not move in a favorable direction, or they are out-of-the-money at expiration date. Additionally, many profitable options are closed out by selling them in the market rather than exercising, to realize the profit and avoid the capital outlay and loss of time value associated with exercising.
What happens after an option is exercised?
After an option is exercised, the option contract is fulfilled. If it was a call option, the holder now owns the underlying shares. If it was a put option, the holder has sold the underlying shares. The financial gain or loss is realized, and the shares are recorded in the investor's brokerage account or the proceeds from the sale are credited.