The basic premise of options are that they are financial contracts that give the holder the right, but not the obligation, to buy or sell an underlying security at a fixed price. Should the holder choose to enforce their right under the terms of the contract, they are said to be exercising their option.
What happens when options are exercised is a fairly complicated process, although from a trader’s point of view it's actually relatively simple to exercise. Because there may well be occasions when you want to do this, you do need to know how to. It can also help to understand the process that then takes place, even if the end result is all that really matters.
It's also important to understand why you would want to exercise an option, and what the disadvantages of doing so may be. On this page we cover all this information to give you an idea of when you should be exercising, and exactly what is involved.
- Why Exercise?
- Disadvantages of Exercising
- How Exercising Works
Why Exercise?
When you first start out trading options you should be aware of one very important fact; it isn't necessary to exercise in order to make a profit. A lot of beginner traders look to make profit by exercising options when there's a return to be made, but this isn't the only way to make money and it's rarely the right thing to do. Statistics have shown that traders tend to make their returns through closing positions by buying or selling options rather than exercising them. This is basically because it's usually more profitable to do so.
However, there are some reasons why exercising is the right thing to do, so there may be occasions when you do want to. The most common reason for exercising is when you own call options based on an underlying security and you decide you actually want to own that underlying security.
For example, you may have bought options on a particular stock, expecting that stock to go up in value. If the stock does indeed go up in value, you may decide that the stock represents a solid long term investment and you feel you would like to take a long term position. You could exercise your option, buy the stock at the favorable price, and then hold on to it.
You may also want to exercise a call option if it was based on underlying stock that was due to pay a dividend. You could exercise, buy the stock, receive your dividend, and then either sell the stock or keep hold of it. Another reason for exercising could be if you had specifically bought put options to protect yourself against a fall in price of stocks that you already owned. You could exercise to dispose of your stocks at a favorable price.
A number of possible reasons for exercising depend on what sort of strategies you are using. There isn't necessarily a right or wrong decision when it comes to exercising; it ultimately comes down to what's right for you at any given time and it can also depend on a number of factors. You should always try and determine what course of action gives you the best result, and be aware of the potential disadvantages of exercising.
Disadvantages of Exercising
There are two main disadvantages of exercising, and it's basically these reasons that lead most options traders to sell profitable contracts rather than exercise them. The first disadvantage is a simple one, and that is the cost involved.
The commissions that you incur through exercising call options and then selling the underlying security, or buying the underlying security and then exercising put options, are likely to be noticeably higher than the costs of simply selling the contracts for a profit.
You may also need to have a significant amount of cash on hand to facilitate such transactions, whereas you don’t need any additional funds to sell options that you own.
The second disadvantage relates to the extrinsic value of options contracts. The price of an option is made up of two distinct components: intrinsic value and extrinsic value. Intrinsic value is the tangible part of the price and is basically the built in profit option. For example, if you have call options on stock that's trading higher than the strike price of them, then the intrinsic value is the difference between the current trading price of the stock and the strike price. This is the profit you could theoretically make by exercising.
The second part of the price is extrinsic value, and that relates to factors other than the price of the underlying asset. It basically represents the potential for an options contract to deliver profit, and serves to compensate the writer of those contracts for the risk they are taking. At the point of exercising a contract, the contract effectively ceases to exist and so all extrinsic value is therefore lost.
If you own options contracts that are in the money (meaning there is profit to be made through exercising), then the price of those options contact will be made up of both intrinsic value and extrinsic value. If you sell them on the exchanges you would therefore benefit from both the intrinsic value and the extrinsic value, whereas if you exercised them you would only benefit from the intrinsic value.
Although it's not always entirely that straightforward, the basic principle suggests that there's usually more money to be made from selling than there would be from exercising.
How Exercising Works
If you do have options contracts that you wish to exercise then the process is actually relatively simple; all you have to do is instruct your broker to exercise them for you. If you are using an online broker, then it's usually a simple process of clicking a button in the trading platform. Your broker will then take the necessary steps to exercise.
If you are exercising a call option, then you will purchase the relevant amount of the related underlying security. You can then choose to either sell that underlying security or hold on to it. If you are exercising a put option, then you will sell the relevant amount of the related underlying security, assuming you own it. If you don't own any of the underlying security, then you may have to buy it before exercising.
You should be aware that only American style contracts can be exercised prior to the expiration date. If you own European style contracts, then you cannot exercise them until the expiration date, at which point they will usually be automatically exercised if they are in profit.
Although the process for you to exercise is as simple as described above, there's actually a series of events that take place behind the scenes.
First, your broker would send an exercise notice to the relevant clearing house, depending on what options are being exercised and where. An options clearing house has the responsibility for ensuring that all contracts are settled according to the relevant. The largest clearing organization is the OCC – Options Clearing Corporation.
Once the clearing organization receives the exercise notice, they then select a member firm that is short on the contract being exercised i.e., a firm that has previously written these contracts. The selection process is usually random; any firm that's short on the relevant contracts can be chosen.
The firm that is selected is then responsible for fulfilling the terms of the contract; delivering the underlying security if it's a call option being exercised or paying for the underlying security if it's a put option. In turn, the firm will then selects one of its account holders which is short on the relevant contract and issues them with what is known as an assignment – meaning that they have to fulfill the terms of the contracts that they had previously written.
It should be noted that there is no direct relationship between the holder of options and the writer of them; basically anyone that has written specific contracts can receive the assignment when those specific contracts are exercised. The whole process sounds somewhat complicated, but it actually all happens very quickly and the net result is then reflected in your own trading account.
