Key Takeaways
- Activates right to buy or sell underlying asset.
- Caller buys shares; putter sells shares at strike.
- Triggers seller's obligation regardless of market price.
- Most in-the-money options auto-exercise at expiration.
What is Exercise?
Exercise refers to the action taken by an option holder to activate their right to buy or sell the underlying asset at the strike price before or at expiration. Exercising converts the option from a derivative contract into an actual transaction involving shares or other assets.
This process applies to both call options, where you buy shares, and put options, where you sell shares, obligating the option writer to fulfill the terms.
Key Characteristics
Understanding exercise involves recognizing its essential traits and how it impacts your rights and obligations.
- Right but not obligation: You can choose to exercise, but you are not required to do so before expiration.
- Triggers asset transaction: Exercising transforms the option into a purchase or sale of the underlying shares at the strike price.
- Varies by option style: American options allow exercise any time before expiration, unlike European options which limit exercise to expiration day.
- Standard contract size: Exercising typically involves 100 shares per option contract.
- Automatic exercise: Brokers often automatically exercise options that are in-the-money by a small margin at expiration.
How It Works
To exercise an option, you first decide if the intrinsic value justifies the transaction after accounting for fees and commissions. For American-style options, you can exercise any time before expiration by notifying your broker, who then submits the exercise instruction to the clearinghouse.
The Options Clearing Corporation assigns the obligation to a seller holding a short position. Upon exercise, the seller must deliver shares (for calls) or purchase shares (for puts) at the strike price, regardless of the current market price. This process often requires sufficient buying power or share ownership in your brokerage account.
Examples and Use Cases
Exercising options can be strategic depending on market conditions and your investment goals.
- Airlines: Investors holding options on Delta may exercise calls when the stock price exceeds the strike price to purchase shares below market value.
- Dividends and early exercise: Exercising before ex-dividend dates may capture dividends, a scenario explored under early exercise.
- Day traders: A day trader might exercise options to quickly convert positions into shares for intraday strategies.
Important Considerations
Before exercising, consider if exercising is the most profitable action compared to selling the option itself. Exercising requires sufficient capital or share ownership and may involve transaction costs reducing net gains.
Your choice should account for timing, option style, and alternatives like selling the option contract. For managing these factors effectively, exploring best online brokers can help you find platforms with tools and support suited for option exercises.
Final Words
Exercising an option turns your contract into an actual stock transaction, which can be profitable if the option is in-the-money after fees. Review your position and costs carefully before deciding to exercise or let the option expire. Consider consulting your broker to understand the best move based on your financial goals.
Frequently Asked Questions
Exercising an option means the buyer activates their right to buy or sell the underlying asset at the predetermined strike price, turning the option contract into an actual transaction of the asset.
When exercising a call option, the holder buys 100 shares per contract at the strike price, which is profitable if the market price is higher than the strike price, allowing purchase below market value.
Exercising a put option means the holder sells 100 shares per contract at the strike price, which is beneficial if the market price is below the strike price, enabling sale above the current market value.
If you don’t exercise your option before expiration, it expires worthless and you lose the premium paid. However, many brokers automatically exercise in-the-money options at expiration if profitable.
To exercise, you notify your broker who submits an exercise notice to the Options Clearing Corporation, triggering the seller’s obligation to fulfill the contract terms before the option expires.
You should consider fees, commissions, and any remaining time value, as these transaction costs can reduce your overall profit when exercising an option.
Exercising converts the option into a transaction of the underlying asset, while trading the option means buying or selling the option contract itself without taking ownership of the asset.
