What Is Exercising Options?
Exercising options refers to the act of using the contractual right granted by an option contract to buy or sell the underlying asset at the predetermined strike price. This action converts the option into shares of the underlying security (for equity options) or a cash settlement. It is a key component of derivatives trading, a broad financial category that includes contracts whose value is derived from an underlying asset.
When an option holder decides to exercise, they are essentially activating the terms of the agreement. For a call option, exercising means purchasing the underlying asset at the strike price. Conversely, for a put option, exercising means selling the underlying asset at the strike price. This process typically occurs through a brokerage firm, which then interacts with the Options Clearing Corporation (OCC) to facilitate the transaction.
History and Origin
The concept of options trading, including the act of exercising them, dates back centuries. One of the earliest recorded instances involves the ancient Greek philosopher Thales of Miletus, who reportedly used a form of options to profit from an anticipated olive harvest around 600 BCE. He secured the right to use olive presses by paying a fee, and then leased them at a higher price when the harvest was abundant, demonstrating the fundamental premise of options: the right, but not the obligation, to engage in a future transaction34, 35.
However, the formalization and standardization of options trading, which made exercising options a more structured process, largely began in the 20th century. A pivotal moment was the establishment of the Chicago Board Options Exchange (CBOE) in 197331, 32, 33. Before the CBOE, options were traded over-the-counter (OTC), often lacking transparency and standardized terms29, 30. The CBOE introduced formal contracts with clear rules, pricing mechanisms, and regulations, transforming options from a niche strategy into a mainstream financial tool28. The CBOE, created as a spin-off from the Chicago Board of Trade (CBOT), standardized contract size, strike price, and expiration dates, and established centralized clearing through the Options Clearing Corporation, addressing concerns about contracts not being honored26, 27.
Key Takeaways
- Exercising options is the act of converting an option contract into the underlying asset or a cash settlement.
- For a call option, exercise means buying the underlying at the strike price; for a put, it means selling the underlying at the strike price.
- The decision to exercise an American-style option can be made at any time before expiration, while European-style options can only be exercised at expiration.
- Options are generally only exercised if they are in-the-money.
- Automatic exercise (Exercise-by-Exception) is common for in-the-money options at expiration, unless contrary instructions are given.
Formula and Calculation
While there isn't a direct "formula" for exercising options, the decision to exercise is driven by the comparison of the option's intrinsic value to the current market price of the underlying asset.
For a call option, the intrinsic value is:
For a put option, the intrinsic value is:
An option is considered in-the-money when its intrinsic value is positive. If the option is out-of-the-money (meaning its intrinsic value is negative), exercising it would result in a loss, as the market price is more favorable than the strike price. Therefore, options are typically only exercised if they are in-the-money. The total cost or proceeds from exercising also needs to factor in the premium originally paid for the option.
Interpreting the Exercising Options
The act of exercising options is a direct action taken by the option holder to realize the value of their contract. For a call option holder, exercising means they believe acquiring the underlying shares at the strike price is more advantageous than buying them on the open market, or they wish to hold the shares for other reasons. Conversely, a put option holder exercises when they believe selling the underlying shares at the strike price is more advantageous than selling them on the open market, or they want to close out a short position.
The decision to exercise an option, especially an American-style option that can be exercised at any time before expiration, is a strategic one. While European-style options can only be exercised at expiration, American-style options present the possibility of early exercise. Factors influencing this decision include the payment of dividends by the underlying company, interest rates, and avoiding certain transaction costs22, 23, 24, 25. For example, a call option holder might exercise before a significant dividend payment to receive the dividend. However, it is often more financially advantageous to sell the option itself in the secondary market rather than exercising it, as the option's price typically includes its time value, which would be forfeited upon exercise.
Hypothetical Example
Imagine an investor, Sarah, buys a call option contract for Company XYZ with a strike price of $50 and an expiration date in three months. The contract covers 100 shares. She paid a premium of $2 per share, totaling $200 for the contract.
Currently, Company XYZ's stock is trading at $55 per share. Sarah's call option is in-the-money because the current stock price ($55) is higher than the strike price ($50).
If Sarah decides to exercise her option:
- She informs her broker of her intention to exercise.
- Her broker, through the Options Clearing Corporation, facilitates the purchase of 100 shares of Company XYZ stock for her at the strike price of $50 per share.
- The total cost to acquire the shares would be $50 x 100 = $5,000.
- After acquiring the shares, Sarah now owns 100 shares of Company XYZ, which are currently worth $55 per share on the open market, totaling $5,500.
- Her gross profit from the exercise is $5,500 (market value) - $5,000 (cost to exercise) = $500.
- Her net profit, considering the initial premium paid, is $500 (gross profit) - $200 (premium) = $300.
Alternatively, if Company XYZ's stock price had fallen to $45, Sarah's call option would be out-of-the-money. Exercising it would mean buying shares at $50 that are only worth $45, resulting in a loss. In this scenario, she would likely let the option expire worthless, losing only the initial premium of $200.
Practical Applications
Exercising options has several practical applications in financial markets and personal finance:
- Acquiring or Disposing of Shares: The most direct application is to acquire shares of an underlying stock (via a call option) or dispose of them (via a put option) at a specific price. This can be used by investors who want to take a long-term position in a stock or protect existing holdings.
- Employee Stock Options: Employees often receive employee stock options as part of their compensation. Exercising these options allows them to purchase company shares, often at a favorable strike price, and potentially sell them for a profit21.
- Arbitrage Opportunities: Sophisticated traders might exercise options to capitalize on slight price discrepancies between the option and the underlying asset across different markets, although such arbitrage opportunities are typically short-lived due to efficient market mechanisms.
- Covered Call Strategies: An investor holding shares of a stock might sell covered call options against their shares. If the call option is exercised by the buyer, the investor's shares are "called away" at the strike price, generating income from both the premium and the sale of the shares.
- Risk Management: While often achieved by selling the option, exercising a put option can be a way to effectively sell shares at a guaranteed price, thereby limiting potential losses on a stock holding. This falls under the broader umbrella of hedging strategies.
The regulatory environment around options exercise is overseen by bodies like the U.S. Securities and Exchange Commission (SEC) and various exchanges. For instance, the SEC's rules, in conjunction with those of exchanges like Nasdaq and the Chicago Board Options Exchange (CBOE), govern the procedures for exercising options, including submission deadlines and automatic exercise protocols17, 18, 19, 20. Market activity in options is closely monitored by financial news outlets, providing insights into trading volumes and trends12, 13, 14, 15, 16.
Limitations and Criticisms
While exercising options provides a direct way to realize the value of a contract, it also comes with limitations and criticisms, particularly concerning the optimal strategy for option holders.
One primary criticism, especially for American-style call options on non-dividend-paying stocks, is that exercising early often means sacrificing the option's remaining time value. An option's price is composed of its intrinsic value and its time value. By exercising, the holder only captures the intrinsic value, and the time value, which represents the potential for the option to become more profitable before expiration, is lost. Therefore, it is often more financially beneficial to sell the option in the secondary market rather than exercising it, as selling allows the holder to capture both the intrinsic and time value. This concept is often referred to as "never exercise a call early"10, 11.
However, there are exceptions and situations where early exercise of an American-style option can be rational. These exceptions often arise due to financial frictions such as high short-sale costs, significant transaction costs, or funding costs8, 9. For example, if an investor holds an in-the-money call option and faces very high costs to short the underlying stock, exercising the call to acquire the stock might be a more cost-effective way to establish a long position than buying the stock on the open market and then having to cover the short. Similarly, early exercise of a put option might be optimal when facing certain interest rate environments or seeking to convert a risky asset into a risk-free bond6, 7.
Despite these nuances, a common pitfall for less experienced option traders is to exercise options when selling them would yield a better financial outcome. Understanding the components of an option's value – time decay and intrinsic value – is crucial to avoid sub-optimal decisions related to exercising options.
Exercising Options vs. Assigning Options
The terms "exercising options" and "assigning options" are often discussed together in the context of options trading, but they refer to distinct actions taken by different parties in an options contract.
Exercising options is the action taken by the option holder (the buyer). When an option holder exercises their right, they are initiating the transaction to buy (for a call option) or sell (for a put option) the underlying asset at the agreed-upon strike price. This is a decision made by the individual who paid the option premium and holds the long position in the contract.
Assigning options, on the other hand, is the action taken by the option writer (the seller). When an option holder exercises their option, the Options Clearing Corporation (OCC) randomly assigns the obligation to fulfill that contract to an option writer who holds a short position in the same option series. The assigned option writer then has the obligation to sell (for a call option) or buy (for a put option) the underlying asset at the strike price. This is not a voluntary decision for the writer; it is an obligation triggered by the holder's exercise. The writer of an option receives the premium, accepting the obligation to be assigned.
The confusion between the two terms arises because one action directly triggers the other. When an option holder exercises, an option writer gets assigned. However, the agency and initiative lie with the option holder in the act of exercising, while the option writer is a passive recipient of the assignment notice.
FAQs
When should I exercise an option?
Generally, you should exercise an American-style call option only at expiration, or just before a significant dividend payment, to avoid losing the option's time value. For American-style put options, early exercise might be optimal under certain conditions, such as a very deep in-the-money position, to capture gains and potentially convert a risky asset into a more secure one. Eu3, 4, 5ropean-style options can only be exercised at their expiration. In many cases, it may be more profitable to sell the option in the open market rather than exercising it, as selling allows you to capture both intrinsic and time value.
Can I exercise an out-of-the-money option?
While technically possible with some brokers, it is almost never financially sensible to exercise an out-of-the-money option. Doing so would mean buying shares at a higher price than the market value (for a call) or selling shares at a lower price than the market value (for a put), resulting in an immediate loss. Options that are out-of-the-money are typically allowed to expire worthless.
What happens if I don't exercise my in-the-money option?
If your American-style option is in-the-money at expiration and you take no action, it will generally be automatically exercised through a process called Exercise-by-Exception (Ex-by-Ex) by the Options Clearing Corporation (OCC), provided it's in-the-money by a certain amount. Fo1, 2r European-style options, they are automatically exercised if they are in-the-money at expiration. If you do not wish for your in-the-money option to be exercised, you must submit "contrary instructions" to your broker by the designated deadline.
What are the fees associated with exercising options?
When exercising options, you typically incur commissions or fees from your brokerage firm for executing the buy or sell order of the underlying shares. Additionally, there might be regulatory fees. These fees can vary by broker, so it's important to understand your broker's fee structure before exercising.
Is exercising options the same as trading options?
No, exercising options is distinct from trading options. Trading options involves buying and selling the option contracts themselves in the secondary market before their expiration. This allows investors to profit from changes in the option's premium without ever taking ownership of the underlying asset. Exercising, on the other hand, is the act of converting the option into the underlying asset or a cash settlement, typically with the intention of holding or disposing of the underlying asset.