Option exercise: Meaning, Criticisms & Real-World Uses

What Is Option Exercise?

Option exercise refers to the act of an option holder formally invoking their right to buy or sell the underlying asset as stipulated by an option contract. This action is a fundamental aspect of options trading, a segment of financial markets falling under derivatives. When an option holder exercises their right, the corresponding obligation is placed upon the option writer, known as option assignment.

History and Origin

The concept of options has roots dating back to ancient Greece, with philosopher Thales of Miletus reportedly profiting from predicting a strong olive harvest and securing rights to olive presses. However, the modern, standardized options market began to take shape much later. A pivotal moment occurred in 1973 with the establishment of the Chicago Board Options Exchange (CBOE) and the Options Clearing Corporation (OCC). The CBOE was the first exchange to list standardized, exchange-traded stock options, initiating trading on April 26, 1973. This standardization, which included fixed contract sizes, strike price, and expiration dates, alongside centralized clearing, revolutionized options trading by providing a liquid and transparent marketplace.⁹,⁸,,⁷

Key Takeaways

Option exercise is the act by an option holder to claim the rights granted by their contract.
For call options, exercise means buying the underlying asset at the strike price; for put options, it means selling the underlying asset at the strike price.
An option is typically exercised only if it is in-the-money (ITM) at or near its expiration.
Most options are closed out before expiration through a closing trade rather than being exercised, to capture both intrinsic value and extrinsic value.
Automatic exercise typically occurs for in-the-money options at expiration, unless the holder provides contrary instructions.

Formula and Calculation

While there isn't a direct "formula" for the act of option exercise itself, the financial outcome of exercising an option can be calculated. The profit or loss derived from option exercise depends on the difference between the underlying asset's market price and the option's strike price, minus the premium paid (for the buyer) or plus the premium received (for the seller).

For a call option holder:

\text{Profit/Loss} = (\text{Market Price of Underlying} - \text{Strike Price}) \times \text{Contract Multiplier} - \text{Premium Paid}

For a put option holder:

\text{Profit/Loss} = (\text{Strike Price} - \text{Market Price of Underlying}) \times \text{Contract Multiplier} - \text{Premium Paid}

The contract multiplier is typically 100 for standard equity options, representing 100 shares of the underlying stock. It's important to note that the premium paid for the option reduces the total profit.

Interpreting the Option Exercise

Option exercise signifies the enforcement of the contractual right held by the long position. For a call option, exercising means purchasing the underlying security at the predetermined strike price, even if the market price is higher. For a put option, it means selling the underlying security at the strike price, even if the market price is lower. This action is generally undertaken when an option is significantly in-the-money, meaning it holds substantial intrinsic value. Options that are out-of-the-money (OTM) or at-the-money (ATM) are rarely exercised, as doing so would result in a financial loss or no gain.

Hypothetical Example

Consider an investor who bought a call option on XYZ Company with a strike price of $50 and an expiration date one month away, paying a premium of $3 per share (total $300 for a standard 100-share contract).
A week before expiration, XYZ Company's stock price rises to $58 per share. The option is now in-the-money.
The investor decides to exercise the option. This means they will pay $50 per share to acquire 100 shares of XYZ Company stock, totaling $5,000. Immediately after acquiring the shares, they could sell them in the open market at the current price of $58 per share, receiving $5,800.
The gross profit from the stock transaction is $5,800 (sale proceeds) - $5,000 (purchase cost) = $800.
After accounting for the initial premium paid ($300), the net profit from the option exercise is $800 - $300 = $500.

Practical Applications

Option exercise is a critical component of the options market, enabling holders to profit from favorable price movements of the underlying asset. For investors holding call options, exercising allows them to acquire shares at a lower fixed price, while put option holders can sell shares at a higher fixed price, providing a form of insurance or profit in declining markets. The Securities and Exchange Commission (SEC) regulates options trading to ensure fair and orderly markets, with rules governing contracts and their exercise.⁶,⁵ Many investors, particularly retail traders, engage in options trading, often through broker-dealer platforms, seeking leverage or to hedge existing stock positions. The growth in retail participation has prompted increased scrutiny regarding investor protection and risk management in the options market.⁴

Limitations and Criticisms

Despite its utility, option exercise also presents limitations and criticisms. A primary critique is that exercising an option typically results in the forfeiture of its extrinsic value, which is the portion of the option's premium beyond its intrinsic value, reflecting factors like time until expiration and implied volatility. For this reason, many option holders prefer to sell their in-the-money options in the open market before expiration rather than exercising them, as selling allows them to capture both intrinsic and extrinsic value.³

Furthermore, research indicates that retail investors often face significant losses in the options market due to behaviors such as overpaying for options relative to realized volatility, incurring high transaction costs, and holding positions for too long, particularly around earnings announcements.²,¹ The complexity of options, coupled with their inherent leverage, means that while gains can be substantial, a total loss of the investment is also possible if the option expires out-of-the-money (OTM). This highlights the importance of thorough understanding and risk management in options trading.

Option Exercise vs. Option Assignment

While closely related, option exercise and option assignment are distinct concepts in options trading. Option exercise is the action taken by the option holder (the buyer) to activate the rights granted by the contract. This means the buyer of a call option chooses to purchase the underlying asset at the strike price, or the buyer of a put option chooses to sell the underlying asset at the strike price.

Conversely, option assignment is the obligation placed upon the option writer (the seller) when an option holder chooses to exercise their contract. If a call option is exercised, the call writer is assigned the obligation to sell the underlying asset at the strike price. If a put option is exercised, the put writer is assigned the obligation to buy the underlying asset at the strike price. Assignment is typically random among those holding short positions in the exercised option series. Essentially, exercise initiates the process, and assignment is the resulting fulfillment of the obligation on the seller's side.

FAQs

Q: Is it always beneficial to exercise an in-the-money option?
A: Not necessarily. While an in-the-money (ITM) option has intrinsic value, it may also have extrinsic value (time value) remaining. Exercising the option means you give up this extrinsic value. It is often more financially advantageous to sell the option on the open market before expiration to realize the full premium, which includes both intrinsic and extrinsic value.

Q: What happens if I don't exercise my in-the-money option?
A: Most in-the-money equity options are automatically exercised at expiration by the Options Clearing Corporation (OCC) unless you give specific instructions to your broker-dealer not to. This is known as "expiration processing" or "auto-exercise."

Q: Can I exercise an out-of-the-money option?
A: You have the right to exercise an out-of-the-money (OTM) option, but doing so would result in an immediate financial loss. For a call option, you would buy the underlying asset at a price higher than its current market value. For a put option, you would sell it at a price lower than its current market value. Therefore, exercising an OTM option is generally not advised.

Q: When is option exercise most common?
A: Option exercise is most common when an option is deeply in-the-money (ITM) and nearing or at its expiration date. It can also occur if a holder wants to acquire or dispose of the underlying asset directly, for example, to participate in a dividend payment.