What Does it Mean to Exercise an Option?
For stock traders, options offer the power to capitalize on price speculation. They give investors control over when, how and even if they choose to buy or sell an underlying security. When they do, it’s called exercising the option. In basic terms, it means they’re choosing to activate a pre-purchased contract with certain rights attached to it.
Each day, investors exercise millions of options, purchased days, weeks or months ago. In doing so, they capitalize on the current market price of a security based on the assumption they made whenever they bought the options contract. The opportunity to exercise it means they’re likely due a profit.
Here’s a look at what it means to exercise an option, including a brief recap on how options work, the different types of options and the decisions investors need to make before they exercise.
A Quick Recap of Derivatives and Options
Before we dive into options and exercising, remember what options are: derivatives. When investors purchase an options contract, they’re not transacting a security—they’re buying the right to transact that security sometime in the future. No shares change hands until the investor exercises the contract.
For example, you pay $100 to buy a three-month call option priced at $1. The contract allows you to buy 100 shares of ABC Company stock at $30 anytime within the next three months. No matter the current price, your contract gives you the power to buy at $30.
It’s important to understand the concept of derivatives before dabbling in options. Recognizing the speculative nature of derivatives and knowing how to use them as a hedge against something like short-selling is a fundamental part of options trading.
The Decision to Exercise an Option
Buying an options contract means making a speculative bet on the future price of a security. Because they’re paying for the contract (not the security), investors need to make a choice in the future: exercise the contract or let it expire.
Exercising the contract means buying or selling the shares contingent on the details of the contract—namely, the exercise price. If the investor’s thesis about stock price is correct, they’ll make money on the contract. At that point, the investor transacts the security itself and the contract terminates, having served its purpose.
If the investor’s speculation about stock price is wrong, they can choose not to exercise an option. For example, if their strike price is $30 and the current share price is $20, they wouldn’t want to buy it at a $10 premium. In this instance, the investor would not exercise the option, instead, letting it expire. The only loss is the money used to secure the option contract.
Exercising Put vs. Call Options
In the same way investors can open a long or short position, options traders can purchase contracts based on whether they believe a stock’s price will rise or fall in the future. Call and put options represent bets on price appreciation and depreciation, respectively.
- Exercising a call option gives investors the ability to buy a security at a specific price, within a specific time frame.
- Exercising a put option gives investors the ability to sell a security at a specific price, within a specific time frame.
If an investor buys a call option, they’re betting that the security’s price will rise and they want the ability to purchase it lower than market value when they exercise the option. Conversely, investors buying put options want the ability to sell a stock at a higher price than it’s trading for at the time they execute the contract.
The most important factor in exercising an option is the exercise price of the contract: the price at which the investor has the right to buy or sell shares. Also called the strike price, this figure is fixed while the stock’s price remains dynamic. It determines whether the contract is in the money or out of the money.
- When the strike price of a call option is lower than the stock, it’s in the money.
- If the strike price of a call option is higher than the stock, it’s out of the money.
- When the strike price of a put option is lower than the stock, it’s out of the money.
- If the strike price of a put option is higher than the stock, it’s in the money.
Options traders always need to be aware of strike price vs. current stock price, to ensure they’re exercising when it’s in the money. If the expiry date for an option comes and it’s out of the money, the option contract expires worthless.
Exercising an Option Takes Patience
There’s a strategic element in deciding whether to exercise an option. Once it’s “in the money,” investors face a gamble. Exercising immediately will net them a profit; however, the share price could continue its trend, increasing the ROI of the option. In other situations, share price can creep into profitable territory, then dip back below the strike price of the option. In options trading, decision-making and timing are everything.
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Those new to options should experiment not only with different types of options, but also strategies for exercising them. Having the confidence to exercise an option based on your current position or thesis can generate big gains (or cover losses). Pay close attention to exercise price and the time remaining on a contract before exercising. And remember, options (like all derivatives) are speculative investments. You won’t win them all.