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Several factors must be considered when you’re deciding if it’s an optimal time to call or buy the shares or put or sell the stock when you’re holding a long call option or a long put option. They include how much time value remains in the option, whether the contract is due to expire soon, and whether you really want to buy or sell the underlying shares.
Key Takeaways
- Knowing the optimal time to exercise an option contract depends on several factors including how much time is left until expiration and if the investor really wants to buy or sell the underlying shares.
- Options can be closed rather than exercised before expiration in most cases through offsetting transactions.
- 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.
Right to Exercise Options
Newcomers usually start by learning the various types of contracts and strategies when they enter the options universe for the first time.
A call option is a contract that grants its owner the right but not the obligation to buy shares of the underlying stock by paying the strike price per share up to the expiration date. A put option represents the right to sell the underlying shares.
The important thing to understand is that the option owner has the right to exercise. You’re not obligated to exercise if you own an option. It’s your choice.
There are good reasons not to exercise your rights as an option owner. Closing the option instead or 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
There are always two sides to an options contract: the buyer and the seller. The holder of a long option contract has rights but the seller or writer has obligations. The call seller’s obligation is to deliver shares at the strike price. The put seller’s obligation is to purchase those shares at the strike price.
They’ve been assigned on the contract when the seller of an option receives notice regarding exercise. The option writer must honor the contract at that point if called upon to fulfill the conditions. It’s too late to close the position when the assignment notice is delivered. They’re required to fulfill the terms of the contract.
The exercise and assignment process is automated. The seller is selected at random from the available pool of investors holding the short options positions and is informed when the transaction takes place. 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.
4 Reasons Not to Exercise an Option
Let’s consider an example of a call option on XYZ Corporation with a strike price of 90 and an expiration in October. The stock is 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 or $950 for one contract because the multiplier for stock options is 100.
- XYZ is currently trading at $99.00.
- You own one XYZ Oct. 90 call option.
- Each call option gives the right to buy 100 shares at the strike price.
- The XYZ Oct. 90 call option is priced at $9.50.
- October expiration is in two weeks.
1. Time Value
Several factors determine the value of an option including the time left until expiration and the relationship of the strike price to the share price. An option with six months of life remaining will be worth more than one with only two weeks remaining if one contract expires in two weeks and another contract on the same stock and at the same strike price expires in six months. It has a greater time value remaining.
The contract is $9 in the money if a stock is trading for $99 and the Oct. 90 call trades $9.50. 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’s trading for $9.50. A contract that’s out-of-the-money such as 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. It would be better to sell the Oct. 90 call at $9.50 rather than exercise the contract by calling the stock for $90 and then selling it at $99. The profit from selling 100 shares for a profit of $9 per share is $900 if the option is exercised. Selling a call at $9.50 equals $950 in options premium. The investor is leaving $50 on the table by exercising the option rather than selling it.
It rarely makes sense to exercise an out-of-the-money contract. There’s no reason to exercise the Oct. 100 call and buy shares for $100 when the market price is $99 and the investor is long the Oct. 100 call and the stock is $99.
2. Increased Risks
The most you can lose is the value of the option or $950 on the XYZ Oct. 90 call when you own the call option. You still own the right to pay $90 per share if the stock rallies and the call will increase in value. It’s not necessary to own the shares to profit from a price increase and you lose nothing by continuing to hold the call option. You effectively sell your option at zero and buy the stock at $90 per share if you decide you want to own the shares instead of the call option and you exercise,
Let’s assume that one week has passed and the company makes an unexpected announcement. The market doesn’t like the news and the stock sinks to $83. It’s lost a lot if you own the call option. Maybe it’s almost worthless. Your account might drop by $950.
Your account value has decreased by $1,600 or the difference between $9,900 and $8,300, however, if you exercised the option and owned stock before the fall. This is less than ideal because you lost an additional $650.
3. Transaction Costs
You’ll typically pay a commission when you sell an option. You usually pay a fee to exercise and a second commission to buy or sell the shares when you exercise. This combination is likely to cost more than simply selling the option and there’s no need to give the broker more money when you gain nothing from the transaction.
The costs will vary, however, 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
You now own the shares when you convert a call option into stock by exercising. You must use cash that will no longer be earning interest to fund the transaction or borrow from your broker and pay interest on the margin loan. You’re losing money with no offsetting gain in both cases. Just hold or sell the option and avoid additional expenses instead.
Many options are subject to automatic exercise at expiration depending on their type. Any contract that’s in the money at expiration will be exercised per the rules of the Options Clearing Corporation if it’s subject to automatic exercise.
Two Exceptions
A stock occasionally pays a big dividend and exercising a call option to capture the dividend may be worthwhile. Or you may not be able to sell it at fair value if you own an option that’s deep in the money. It may be preferable to exercise the option to buy or sell the stock if bids are too low. Do the math.
What Is the Strike Price?
The strike price is the price that’s set for the exercise of an option. The seller or writer of the option determines it and it’s more or less carved in granite because it’s not affected by fluctuations in share price.
How Does Time Value Factor Into an Investment?
The term “time value” is often associated with money but it applies to options and anything else of value as well. The theory states that money or an asset is worth more at present than it may be in the future. The asset or cash can work for you in the present and create additional revenue.
What Is Intrinsic Value?
An investment’s intrinsic value is based on its ability to produce cash flow. It measures an aspect of the investment’s performance. Not all assets have cash flow, however, so intrinsic value can be tricky to pin down.
The Bottom Line
There are solid reasons for not exercising an option before and into the expiration date. It’s often wrong to exercise an option rather than sell it unless you want to own a position in the underlying stock. Be sure to close it through an offsetting sale if the contract is in the money heading into the expiration and you don’t want it exercised. The contract may otherwise be automatically exercised per the rules of the Options Clearing Corporation.
Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.