When an option contract is exercised, the owner of the option invokes the right to buy or sell stock. Options holders have the right to exercise their option any time before expiration. Exercising an option is the process of buying or selling shares at the option’s strike price. Options buyers are the only party that can exercise an options contract.
When exercising a call option, you are buying the underlying stock at the strike price. Conversely, if you exercise a put option you will be short the underlying stock at the strike price.
The decision to exercise depends on the options contract’s specifications, whether it is an American or European-style option, the underlying’s current price, the options contract’s strike price, the length of time remaining on the options contract, and the option holder’s outlook on the underlying security.
Options holders can exercise the contract anytime before expiration with American-style contracts. Exercising prior to expiration may occur for a number of reasons, such as the desire to receive a dividend payment on the underlying stock or to fulfill an obligation for another position in the portfolio.
How to Exercise an Option?
To exercise an option, you must inform your broker of your decision. Exercising an options contract is irrevocable as exercise begins the process of assignment by the Options Clearing Corporation (OCC).
Exercising an option can be done in two ways: Automatic exercise and manual exercise. In automatic exercise, if your option is set to expire in-the-money (ITM), your broker will automatically convert it into shares at expiration. This happens regardless if you want it to happen or not. Options exercise may involve additional costs. Contact your broker for more information on their specific process for options exercise.
With manual exercise, you are responsible for informing your broker if you want to exercise your options before expiration. This gives you more control of your positions because you can choose when to take profits or cut losses on a position.
When to Exercise an Option
Exercising an option depends on the option type and its expiration date. If you have a call option with a strike price that is lower than the current market price of the underlying stock, it is generally beneficial to exercise the call and buy the stock at the lower strike price. The same goes for put options; if you have a put option with a strike price that is higher than the current market price of the underlying stock, it is generally beneficial to exercise your right and sell your shares at the higher strike price.
It's important to consider how much time value there is in your options when deciding whether or not to exercise them. If there isn't much time left until expiration, then it might be wise to exercise early in order to avoid any risk of losing out on any potential gains. On the other hand, if there's still some time left before expiration, then it might make more sense to wait until closer to expiration in order to maximize any potential gains.
Finally, always keep in mind that exercising an option comes with certain risks and potentially associated costs. For example, when you exercise a call option you are buying shares of stock at their current market prices which could go down shortly after purchase leaving you with losses instead of profits.
Benefits of Exercising an Option Early
Exercising an option early can provide a variety of benefits. It allows the option holder to lock in the current value of the underlying asset and avoid any decrease in value prior to expiration. It also allows them to access dividends or other corporate actions that may be paid on the underlying asset during the period before expiration.
In addition, exercising an option early can also provide liquidity benefits for investors who need access to cash or who want to redeploy funds into different investments. By closing out a position prior to expiration, investors can avoid tying up funds for long periods of time and make more efficient use of their capital.
The benefit of exercising an option early is that you can lock in profits if you believe that market prices will decline. For example, if you own a call option with a strike price of $30 and market prices rise to $35, you could exercise your option and buy 100 shares for $3,000 ($30 x 100) rather than pay $3,500 on the open market. In this case you would make a profit of $500 by exercising early.
On the other hand, there is no benefit to exercising an option early if market prices decline. For example, if you own a call option with a strike price of $30 and market prices drop to $25 then it may be better to wait until expiration as your maximum loss is still limited to whatever premium was paid for that particular contract.