When is it time to exercise an option contract? That's a question that investors sometimes struggle with because it's not always clear if it's the optimal time to call (buy) the shares or put (sell) the stock when holding a long call option or a long put option.
There are a number of factors to consider when making the decision, including how much time value is remaining in the option, whether the contract is due to expire soon, and whether you really want to buy or sell the underlying shares.
Right toExercise Options
When newcomers enter theoptions universe for the first time, they usually start by learning the varioustypes of contracts and strategies.For example, acall option is a contract that grants its owner the right, but not the obligation, to buy 100 shares of the underlying stock by paying the strike price per share, up to the expiration date.
Conversely, a put option represents the right to sell the underlying shares.
Key Takeaways
- Knowing the optimal time to exercise an option contract depends on a number of factors, including how much time is left until expiration and if the investor really wants to buy or sell the underlying shares.
- In most cases, options can be closed (rather than exercised) through offsetting transactions prior to expiration.
- It doesn't make a lot of sense to exercise options that have time value because that time value will be lost in the process.
- Holding the stock rather than the option can increase risks and margin levels in the brokerage account.
The important thing to understand is that the option owner has the right to exercise. If you own an option, you are not obligated to exercise; it's your choice. As it turns out, there are good reasons not to exercise your rights as an option owner. Instead, closing the option (selling it through an offsetting transaction) is often the best choice for an option owner who no longer wants to hold the position.
Obligations to Options
While the holder of a long option contract has rights, the seller or writer has obligations. Remember, there are always two sides to an options contract: the buyer and the seller. The obligation of a call seller is to deliver 100 shares at the strike price. The obligation of a put seller is to purchase 100 shares at the strike price.
When the seller of an option receives notice regarding exercise, they have been assigned on the contract. At that point, the option writer must honor the contract if called upon to fulfill the conditions. Once the assignment notice is delivered, it is too late to close the position, and they are required to fulfill the terms of the contract.
The exercise and assignment process is automated and the seller, who is selected at random from the available pool of investors holding the short options positions, is informed when the transaction takes place. Thus, stock disappears from the account of the call seller and is replaced with the proper amount of cash; or stock appears in the account of the put seller, and the cash to buy those shares is removed.
Four Reasons Not to Exercise an Option
Let's consider an example of a call option on XYZ Corporation with a strike price of 90, an expiration in October, and the stock trading for $99 per share. One call represents the right to buy 100 shares for $90 each, and the contract is currently trading for $9.50 per contract ($950 for one contract because the multiplier for stock options is 100).
- XYZis currently trading at $99.00.
- You own one XYZOct 90 call option.
- Each call option gives the right to buy 100 shares at the strike price.
- The XYZOct 90 call option is priced at $9.50.
- October expiration is in two weeks.
1. Time Value
A number of factors determine the value of an option, including the time left until expiration and the relationship of the strike price to the share price. If, for example, one contract expires in two weeks and another contract, on the same stock and same strike price, expires in six months, the option with six months of life remaining will be worth more than the one with only two weeks. It has greater time value remaining.
If a stock is trading for $99 and the Oct 90 call trades $9.50, as in the example, the contract is $9 in the money, which means that shares can be called for $90 and sold at $99, to make a $9 profit per share. The option has $9 of intrinsic value and has an additional 50 cents of time value if it is trading for $9.50. A contract that is out-of-the-money (say an Oct 100 call), consists only of time value.
It rarely makes sense to exercise an option that has time value remaining because that time value is lost. For example, it would be better to sell the Oct 90 call at $9.50 rather than exercise the contract (call the stock for $90 and then sell it at $99). The profit from selling 100 shares for a profit of $9 per share is $900 if the option is exercised, while selling a call at $9.50 equals $950 in options premium. In other words, the investor is leaving $50 on the table by exercising the option rather than selling it.
Furthermore, it rarely makes sense to exercise an out-of-the-money contract. For example, if the investor is long the Oct 100 call and the stock is $99, there is no reason to exercise the Oct 100 call and buy shares for $100 when the market price is $99.
2. Increased Risks
When you own the call option, the most you can lose is the value of the option or $950 on the XYZ Oct 90 call. If the stock rallies, you still own the right to pay $90 per share, and the call will increase in value. It is not necessary to own the shares to profit from a price increase, andyou lose nothing by continuing to hold the call option. If you decide you want toown the shares (instead of the call option) and exercise, you effectively sell your option at zero and buy the stock at $90 per share.
Let's assume one week has passed and the company makes an unexpected announcement. The market does not like the news and the stock sinks to $83. That's unfortunate. If you own the call option, it has lost a lot, maybe almost worthless, and youraccount might drop by $950. However,if you exercised theoption and owned stock prior to the fall, your account value has decreased by $1,600, or the difference between $9,900 and $8,300. This is less than ideal because you lost an additional $650.
3. Transaction Costs
When you sell an option, you typically pay a commission. When you exercise an option, you usually pay a fee to exercise and a secondcommission to buy or sell the shares.. This combination is likely tocostmorethan simply selling the option, and there is no need to give thebrokermore moneywhen you gain nothing from the transaction. (However, the costs will vary, and some brokers now offer commission-free trading—so it pays to do the math based on your broker's fee structure).
4. Higher Margin Exposure
When you convert a call option into stock by exercising, you now own the shares. You must use cash thatwill no longer be earning interestto fund thetransaction,or borrow cash from your brokerand pay interest on the marginloan. In bothcases, you are losing moneywith no offsetting gain. Instead,just hold or sellthe option and avoidadditional expenses.
Options are subject to automatic exercise at expiration, which means that any contract that is in the money at expiration will be exercised, per rules of the Options Clearing Corporation.
Two Exceptions
Occasionally a stock pays a big dividend and exercising a call option to capture thedividend may be worthwhile. Or, if you own an option that is deep in the money, you may not be able to sell itatfair value. If bids are too low, however, it may bepreferable to exercise the option to buy or sell the stock. Do the math.
The Bottom Line
There are solid reasons for not exercising an option before and into the expiration date. In fact,unless you want to own a position in the underlying stock, it is often wrong to exercise an option rather than selling it. If the contract is in the money heading into the expiration and you do not want it exercised, then be sure to close it through an offsetting sale or the contract will be automatically exercised per the rules of the Options Clearing Corporation.
