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What Does Exercising an Option do and how does it work?

Exercise An Option - Introduction

How do I exercise my option?

Is it even necessary to exercise a profitable option? What happens when you do?

In Options Trading, exercising an option means to enforce your rights to buy the underlying stock if you are holding call options or to sell the underlying stock if you are holding put options.

Yes, call options gives you the right to buy the underlying stock at a specific price while put options gives you the right to sell the underlying stock at a specific price but that right does not happen automatically prior to expiration of the option. Thats right, options are what is known in finance as a "Contingent Claim", which means that a claim is contingent on the holder. The holder decides whether to enforce that right or not and that is known as to "exercise an option".

This tutorial shall cover how to exercise options, what happens when options are exercised and why should options traders exercise options.

How To Exercise An Option?

Exercising an option is as easy as clicking a button or a link in your trading interface if you are using an online options trading broker. Clicking that button informs your broker of your intention to exercise an option which then sets off a complex series of actions that we will be covering in a later section below. When you exercise a call option, you will buy the underlying stock at the strike price of the call option. For instance, if you exercise 1 contract of a $40 strike price call option, you would buy 100 shares of the underlying stock at $40 no matter what price it is at the time of exercise. This price is known as the "Exercise Price". When you exercise a put option, you will sell your shares at the strike price of the put options. For instance, if you exercise 1 contract of $40 strike price put option, you would be selling 100 shares of the underlying stock at $40 no matter what price it is at the time of exercise. If you do not have the underlying stock, you will end up with a short stock position. That's right, you cannot exercise an option unless you are the holder of a long position. If you are short an options contract, you cannot exercise the option.

Please take note that only American Style Options can be exercised before expiration. European Style Options do not offer such flexibility. Most exchange traded options all over the world are American Style Options. All publicly traded equities options in the US market are American Style Options as well. Some index options such as the Nasdaq 100 Index Options are European style options.

Difference between Exercise and Assignment

You exercise an option when you are the holder of an option and you choose to exercise the rights of the options that you own. When that happens the person who sells you the option recieves an "assignment". Yes, assignment is when the options that you wrote through a sell to open order has been exercised by the buyer of the option. The exact procedure is a lot more complex than that but that is the difference between an exercise and an assignment in options trading.

What Happens When an Option is Exercised?

When you exercise an option, a request is sent to your options trading broker that sets off a whole chain of events leading to the eventual resolution of an options contract that will cease to exist after that.

When the exercise request is received by your options broker, that request to exercise an option is sent to the Options Clearing Corporation or OCC in the form of an "Exercise Notice". The Options Clearing Corporation is the entity responsible for ensuring that all options contracts are successfully settled when exercised and is the biggest clearing organization in the world for financial derivative instruments. Once the exercise notice is received by the OCC, the OCC will randomly select a member firm that is short on that same options contract being exercised for assignment. The selected firm then fulfills the terms of the options contract by delivering the underlying stock if it is a call option being exercised or by paying for the underlying stock if it is a put options that is being exercised. After that, the selected firm selects one or more of its account holders who are short that same options contract for assignment. The delivery of the stocks or the paying for the stocks by the firm would come from these selected assignees. Every broker or firm would have their own procedure for selecting accounts for assignment but the most commonly used method is random selection. This whole complex process takes place all within just a few minutes with the net result reflected in your account.

Process When You Exercise An Option

As you can see from the above process, it is really the OCC that is fulfilling the other side of the contract when you exercise an option. There is no direct connection between you and the options writer. This is how the OCC guarantees performance on every options contract; by obligating itself for all fulfillments. After that, the OCC selects member firms for assignment in order to close the whole process. As such, there is really no worry as to whether or not the party taking the opposite side of your option has the stocks or the money to fulfill your exercise because it is really the OCC that is dealing with you, not another options trader.

Exercise An Option - Case Study

John owns 2 contracts of AAPL's $190 strike price call options and has $40,000 cash in his account. Peter owns 2 contracts of AAPL's $190 strike price put options and has 200 shares of AAPL in his account.

Both John and Peter decides to exercise their options.

At the end of the exercise, John's account now consists of 200 shares of AAPL stocks bought at $190 per share for a total of $38,000 and remaining cash of $2000. Peter's account now consists of $38,000 and no shares as he sells his 200 shares of AAPL at $190 per share in accordance with the terms of the put options.

Why Should Options Traders Exercise Options?

The question that most options trading beginners ask is whether or not it is necessary to exercise an option in order to take profit on it? Well, the answer simply is, No. In fact, most options traders don't exercise options in order to take profit. According to the OCC, for the year of 2008, 69.4% of all options were closed out before they expire. This means that 69.4% of options traders simply sell their options in order to take profit or cut loss. Only 11.6% of all options contracts were exercised with only 19% of all options contracts expiring worthless. Of course this statistic totally busted the myth that more than 80% of all options contracts expire worthless which has been the basis behind some theories such as Options Pain.

In fact, taking profit on a profitable options position by selling the position rather than exercising it can actually be more profitable if you are not using any options trading strategies that depends on time decay for profit. This is because apart from the value gained in intrinsic value, the option would probably still have some extrinsic value left. If you exercise such an option, you would instantly lose all extrinsic value remaining in the option.

Lets assume that you bought AAPL's $170 strike price call options for $1.30 when it was trading at $170.

AAPL rallies to $190 and your $170 strike price call options are now worth $21.00.

If you exercised the option and bought AAPL for $170 and then sold it for the prevailing price of $190, you would make a total of $190 - $170 - $1.30 = $18.70.

However, if you simply sold the options off at its current price of $21.00, you would have make a total of $21.00 - $1.30 = $19.70.

See? You would have made $1 more if you sold the option rather than exercise it in this example. This is because the options still have $1 extrinsic value left when AAPL rallies to $190. The above calculation did not take into consideration the fact that the process of exercising the options and then selling the stocks at market price separately incurs a lot more commissions than just selling the options outright.

So, why should any options traders exercise an option?

Well, there are two main reasons why an options trader would exercise an option. Firstly, that options trader wants to move from a short term options bet to a long term investment on the underlying stock. Sometimes a stock could look so promising for the long term that the options trader actually wants to keep it for long term investment purpose. That could be the main motivation behind exercising a call option. Secondly, the options trader has stocks that he wants to get rid of at a good price. That could be the main motivation behind exercising a put option.

Exercise An Option - Advantages

:: Useful when you want to switch from owning the options to owning the stocks itself for long term investment. :: Useful when you wish to sell your stocks at a favorable price by exercising a put option. :: When dividend paid out by owning the stock is higher than the remaining extrinsic value of a call option.

Exercise An Option - Disadvantages

:: All remaining extrinsic value in the option evaporates and the options contract cease to exist. As such, exercising an option may not be as profitable as simply selling a profitable options contract outright. :: Commissions are sometimes higher when you exercise an option than if you simply sell the option.

Exercise An Option Questions

:: Exercising Put Options Without Assets?

:: How Do I Pay For Exercising Profitable Call Options?

:: Exercising Put Options Without Assets?

:: Should I Sell or Exercise My Expiring Call Options?

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