Exercising in Options Trading: What It Means
Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Investors in stock option contracts have the right to buy or sell underlying stocks (or other assets) at a predetermined price within a certain time period. When an investor decides they want to take action on their right to buy or sell, it’s called exercising. There are a number of ways investors can choose to exercise their options contract, depending on their individual goals and financial situation.
Option contracts are complex investment vehicles. They’re a multi-faceted tool that involves precise timing and strategizing. While options are not for all investors, if handled by experienced traders, options could be beneficial for those who understand the risks involved.
Key Points
• Exercising an option involves buying or selling the underlying security at the strike price.
• Call options allow underlying assets to be purchased at a potentially lower price; put options allow underlying assets to be sold at a potentially higher price.
• Options contracts have a limited lifespan; unexercised options contracts expire without value.
• Consider transaction costs, time value, intrinsic value, and risk tolerance before exercising.
• Many options are sold before expiration to capture remaining time value or to avoid exercise costs, but those that remain unexercised by expiration will expire worthless.
What Does Exercise Mean in Options Trading?
Exercising a stock option means that a trader purchases or sells the underlying stock associated with the options contract at the price set by the contract, which is called the strike price. This price may differ from the current market price of the stock.
Options contracts are valid for a certain amount of time in options trading. So if the owner doesn’t exercise their right to buy or sell within that period, the contract expires worthless, and the owner loses the right to buy or sell the underlying security at the strike price.
There is also an upfront fee in options trading, called a premium, that gets paid when a trader enters into an options contract. If the trader doesn’t exercise the contract, they forfeit that fee along with any other brokerage fees. Most options contracts never get exercised. Some contracts are sold instead of exercised, because the contract itself has value if it has the potential to be exercised later.
There are two main choices of types of options contracts, call options and put options. Purchasing a call option gives the buyer the right, but not the obligation, to purchase the underlying security at the strike price. Purchasing a put option gives the buyer the right, but not the obligation, to sell the underlying security at the strike price.
Each contract is different, and there are also different types of options. American-style options let traders exercise them at any time up until and on the contract’s expiration date, while European-style options can only be exercised on the expiration date itself.
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*Check out the OCC Options Disclosure Document.
How Exercising a Call or Put Option Works
Generally, traders have several choices when it comes to exercising their stock options. When a trader is ready to exercise an option, they can let their brokerage firm know. The broker will create an exercise notice to the Options Clearing Corporation (OCC) to let the individual or entity buying or selling the underlying stock know that the trader wants to execute a trade on a particular date. The option seller is required to fulfill the obligations of the contract.
The OCC assigns the exercise notice to one of their clearing members, often the trader’s brokerage firm. The broker then assigns the option to one of their customers who has written an option contract that they have not yet covered. Depending on the broker, the customer they choose may either be chosen randomly or picked on a first-in-first-out (FIFO) principle.
Exercise a Call
Exercising a call option means buying the underlying stock at the option’s strike price. If the stock’s market price is higher than the strike price, you can purchase it at a discounted rate. The key benefit of exercising a call is potential access to those lower rates, especially if the stock has risen significantly. Transaction costs, such as brokerage commissions, can erode potential profits — so consider these factors when deciding to exercise.
For example, say that an investor buys a call option with a strike price of $50. If the stock’s market price rises to $60, they can exercise the option to buy shares at $50 instead of the higher market price. This gives them a $10 per share gain before factoring in the cost of the option and fees. If they don’t want to buy the shares, they could sell the option for a profit instead.
Exercise a Put
Exercising a put option means selling the underlying stock at the strike price. This can be beneficial if the market price falls below the strike price. You can then sell the stock at a higher price than the market price in order to see a profit. Bear in mind that selling a put obligates the seller to buy the underlying asset at the strike price if the option is exercised. There are also brokerage fees associated with exercising a put to consider, as there are with calls.
Say an investor buys a call option with a strike price of $50. If the stock’s market price rises to $60, they can exercise the option to buy shares at $50 instead of the higher market price. This gives them a $10 per share gain before factoring in the cost of the option and fees. If they don’t want to buy the shares, they could sell the option for a profit instead.
How Do You Know Whether to Hold or Exercise an Option?
It can be difficult to know when and whether to exercise an option. There are different options trading strategies that can prove beneficial to exercising early, or to waiting or even selling the option contract itself. Many factors come into play when making the decision to exercise an option, such as:
• Time Value: Understanding how options pricing works is essential, as time value plays a key role in deciding whether to hold or exercise an option. Time value is a critical aspect of options pricing and significantly impacts the decision to. Options may lose value as they approach expiration due to the time decay. If there’s still significant time left on the option, it may be beneficial to hold the option rather than exercising it since it has the potential to be profitable over time. On the other hand, selling could help you capitalize on the remaining time value, since an option with, say, two months left to expiration would have more time value than an option with two weeks left to expiration.
• Intrinsic Value (In-the-Money or Out-of-the-Money): The decision to exercise is often influenced by whether the option is in-the-money. A call option, for example, is in-the-money when the underlying asset’s price is above the strike price. Exercising in such a case allows the trader to buy the underlying asset at a discount. On the other hand, out-of-the-money options hold no intrinsic value and are unlikely to be exercised.
• Transaction Costs and Fees: Exercising an option comes with transaction costs, which can include brokerage commissions and fees. These fees can erode profits, so it’s important to weigh them against potential gains from exercising. In some cases, the cost of exercising an option may outweigh the benefit, especially when the option is close to expiration and there are minimal profits to be gained.
• Risk and Margin Exposure: There can be a significant amount of capital needed to purchase underlying assets, especially with high-priced stocks. This may also involve using a margin account, which increases your exposure to risk and any potential costs associated with holding the position. Be sure to assess your risk tolerance and available capital before deciding to exercise an option.
The Takeaway
When deciding to hold or exercise an option, the top factors are time value, intrinsic value, and your appetite for risk. Holding options could offer the potential for greater returns, but exercising options can provide profits if they are in-the-money. There are also fees and capital gains to consider.
While investors are not able to sell options on SoFi’s options trading platform at this time, they can buy call and put options to try to benefit from stock movements or manage risk.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
FAQ
How are early-exercise options different from exercise options?
Early-exercise options refer to American-style option contracts only, which can be exercised on and at any point before their expiration date. European-style options can only be exercised on their expiration date.
What is a cashless exercise in options?
A cashless exercise occurs when an investor purchases stock without paying cash to do so. The option holder pulls from some of the exercised shares to cover the cost of purchasing the stock. This is more common with employees exercising stock options, rather than in options trading.
What happens when you exercise an option?
Exercising an option means taking action on the right granted by your options contract. For call options, this means buying the underlying stock at the strike price. For put options, this means selling the underlying stock at the strike price. Exercising an option is a commitment to follow through with the contract’s terms: If you choose not to exercise the option, it will expire worthless, and you lose the premium paid to acquire it.
What happens to premium when you exercise a call option?
You do not keep your option premium when you sell a call option. The premium is part of the cost of acquiring the option, and is considered a sunk cost once the option is exercised.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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