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Exercising an option

What Is Exercising an Option?

Exercising an option refers to the act of putting the rights conveyed by an option contract into effect. For the holder of a call option, exercising means purchasing the underlying asset at the predetermined strike price. Conversely, for the holder of a put option, exercising means selling the underlying asset at the strike price. This action is a core component of options trading, a sophisticated area within derivatives markets, and typically occurs when the option holds intrinsic value, meaning it is in-the-money.

History and Origin

The concept of options has roots stretching back centuries, with early forms of contingent contracts appearing in various commercial transactions. For instance, some historians note that contracts with embedded option features were important to commerce in ancient times, and trading in such contracts occurred on exchanges like the Antwerp bourse in the 16th century and the Amsterdam bourse in the 17th century.7 In the United States, over-the-counter options were traded as far back as the late 18th century, but these were unstandardized and privately negotiated.6

A pivotal moment in the history of options occurred with the founding of the Chicago Board Options Exchange (CBOE) in 1973. This event marked the beginning of standardized, exchange-traded options, transforming a previously informal market into an organized, liquid marketplace. The CBOE introduced standardized terms, centralized liquidity, and a dedicated clearing entity, making options more accessible and transparent for investors.5,4 This standardization facilitated wider adoption and the development of more complex options trading strategies.

Key Takeaways

  • Exercising an option is the act by which the option holder uses their right to buy or sell the underlying asset.
  • A call option holder exercises to buy the underlying asset, while a put option holder exercises to sell it.
  • Options are typically exercised when they are in-the-money, meaning they have intrinsic value.
  • The decision to exercise depends on factors like the option's profitability, time until expiration date, and specific trading strategy.
  • Exercising an option results in the delivery of the underlying asset or its cash equivalent, depending on the option type.

Interpreting Exercising an Option

The decision to exercise an option is primarily driven by whether the option is profitable, specifically whether it is in-the-money. For a call option, this means the underlying asset's market price is above the strike price. For a put option, the underlying asset's market price must be below the strike price. If an option is out-of-the-money, exercising it would result in a loss, as it would mean buying an asset for more than its market value (for a call) or selling an asset for less than its market value (for a put).

Furthermore, American-style options can be exercised any time up to their expiration date, while European-style options can only be exercised on the expiration date itself. Traders often prefer to sell their in-the-money options rather than exercising them before expiration, especially for American-style options, to capture any remaining time value in the option premium. Exercising an option typically eliminates any time value the option may still possess.

Hypothetical Example

Consider an investor, Alice, who believes that shares of Company XYZ, currently trading at $50, will increase in value. She decides to buy a call option on XYZ with a strike price of $52 and an expiration date three months away. She pays an option premium of $3 per share, or $300 for one standard option contract covering 100 shares.

Two months later, Company XYZ's stock price rises to $60 per share. Alice's call option is now deep in-the-money, as the market price of $60 is well above her $52 strike price. She has two main choices:

  1. Sell the option: Alice could sell her call option on the open market. The value of her option would have increased significantly due to the rise in the underlying stock price. If the option is trading at $8, she could sell it for $800, realizing a profit of $500 ($800 revenue - $300 cost).
  2. Exercise the option: Alice decides to exercise her option. Through her brokerage account, she instructs her broker to exercise the call. This means she purchases 100 shares of Company XYZ at the strike price of $52 per share, totaling $5,200 (100 shares * $52/share). She then immediately sells these shares on the open market at the current price of $60 per share, receiving $6,000. Her net profit, before commissions, would be $500 ($6,000 received - $5,200 paid for shares - $300 initial option premium).

In this scenario, exercising an option allows Alice to acquire the shares at a discount and immediately realize a profit.

Practical Applications

Exercising an option is a fundamental action in options trading, crucial for investors looking to realize the value of their contracts. It is most commonly applied in situations where:

  • Acquiring or Disposing of Shares: Investors holding call options might exercise to purchase shares of the underlying asset at a favorable price, perhaps to add them to a long-term portfolio or to profit from the price difference. Similarly, those with put options may exercise to sell shares at a guaranteed price, which can be useful for exiting a position or for hedging purposes.
  • Arbitrage Opportunities: In rare cases, discrepancies between an option's market price and its intrinsic value may create an arbitrage opportunity, prompting an immediate exercise and simultaneous offsetting trade to capture a risk-free profit.
  • Dividend Capture: For call options, if a significant dividend is about to be paid, an investor might exercise the option before the ex-dividend date to become a shareholder and receive the dividend. This strategy is less common due to transaction costs and the loss of time value.

The regulation of options trading, including the rules surrounding exercising options, is overseen by bodies such as the Securities and Exchange Commission (SEC) in the United States. These regulations ensure market integrity and investor protection by setting forth clear guidelines for exercising, clearing, and settling option contracts.3

Limitations and Criticisms

While exercising an option provides a direct way to realize an option's value, it comes with certain limitations and criticisms. One primary drawback for option holders is that exercising an option typically means forfeiting any remaining time value. The option premium consists of both intrinsic value (the in-the-money amount) and time value (the value attributed to the remaining time until expiration date and expected volatility). If an option is exercised before its expiration, the time value component is lost. For this reason, many traders prefer to sell their in-the-money options on the open market rather than exercising them, as selling allows them to capture both the intrinsic and time value.

Furthermore, exercising an option can lead to significant capital requirements. If an investor exercises an in-the-money call option, they must have sufficient funds in their brokerage account to purchase the underlying asset at the strike price. Similarly, exercising a put option requires owning the underlying asset to deliver it, or incurring a short position if the put is uncovered. This can expose investors to additional market risk if they do not immediately sell or cover their positions after exercising.

For options writers (sellers), the risk is tied to "assignment," which is the obligation to fulfill the terms of the contract when an option is exercised against them. This can lead to potentially unlimited losses for uncovered call writers if the stock price soars, or significant losses for uncovered put writers if the stock price plummets.2 Entering the wrong trade, such as accidentally selling instead of buying, can also lead to unintended and substantial risks.1 Using a margin account to manage these obligations can mitigate some risks, but also introduces leverage, which can amplify losses.

Exercising an Option vs. Option Assignment

The terms "exercising an option" and "option assignment" represent two sides of the same transaction in options trading. While "exercising an option" refers to the action taken by the option holder, "option assignment" refers to the corresponding obligation placed upon the option writer (seller).

When an option holder decides to exercise their call option or put option, they are initiating the process. This instruction is sent through their broker to the Options Clearing Corporation (OCC). The OCC then randomly assigns this exercise notice to a short option position (an option writer) with the same terms (strike price, expiration date, and underlying asset). The assigned writer is then obligated to fulfill the terms of the contract. For a call option, the assigned writer must sell the underlying asset at the strike price. For a put option, the assigned writer must buy the underlying asset at the strike price.

The key distinction is the party initiating the action and the resulting role: the holder exercises their right, while the writer is assigned an obligation.

FAQs

What happens if I don't exercise an option?

If you do not exercise an option by its expiration date and it is out-of-the-money or at-the-money, the option will expire worthless. In this case, you will lose the entire option premium you paid for the contract. If your option is in-the-money at expiration and you hold an American-style option, it may be automatically exercised by your broker. European-style options would only be exercisable on the expiration date itself.

Can all options be exercised at any time?

No. The ability to exercise an option depends on its style. American-style options can be exercised by the holder at any time up to and including the expiration date. European-style options, conversely, can only be exercised on the expiration date itself. Most stock options in the U.S. market are American-style, while many index options are European-style.

Is it always best to exercise an in-the-money option?

Not necessarily. While an in-the-money option has intrinsic value, it may also have remaining time value. If you exercise the option before its expiration date, you forfeit this time value. Often, selling the option contract on the open market can yield a greater profit or smaller loss compared to exercising, as the sale price typically includes both intrinsic and time value. The decision depends on your goals, the specific option, and your overall speculation or hedging strategy.