Should an Investor Hold or Exercise an Option?

When is it time to exercise an option contract? This is a question that investors sometimes struggle with, as it is not always clear if this is the optimal time to buy (buy) the stock or sell (sell) the stock when holding an option. long call or a long put.

There are a number of factors to consider when making the decision, including the remaining time value of the option, whether the contract is due to expire soon, and whether you really want to buy or sell the option. underlying shares.

Right to exercise options

When newcomers first enter the world of options, they usually start by learning the different types of contracts and strategies. For example, a call 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, until the expiration date.

Conversely, a put option represents the right to sell the underlying shares.

Key points to remember

  • Knowing the optimal time to exercise an option contract depends on a number of factors, including how long until expiration and whether the investor really wants to buy or sell the underlying stock.
  • In most cases, options can be closed (rather than exercised) through offsetting trades prior to expiration.
  • It doesn’t make much 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 risk and margin levels in the brokerage account.

The important thing to understand is that the owner of the option has the right at exercise. If you hold an option, you are not required to exercise it; it’s up to you. It turns out there are good reasons not to exercise your rights as an option holder. 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 towards options

Although the holder of a long option contract has rights, the seller or the writer has obligations. Remember that there are always two parties to an options contract: the buyer and the seller. The obligation of a call seller is to deliver 100 shares to the exercise price. The obligation of a put seller is to buy 100 shares at the strike price.

When the seller of an option receives notice regarding the exercise, they have been awarded on the contract. At this point, the option writer must honor the contract if called upon to fulfill the conditions. Once the assignment notice is issued, it is too late to close the position and they are bound by the terms of the contract.

The exercise and allocation process is automated and the seller, who is randomly selected from the pool of available investors holding the short option positions, is notified when the trade takes place. Thus, the stock disappears from the call seller’s account and is replaced by the appropriate amount of cash; or shares appear on the selling seller’s account, and the money to buy these shares is removed.

Four reasons not to exercise an option

Consider an example call option on XYZ Corporation with a strike price of 90, expiration in October, and the stock trading at $99 per share. A call represents the right to buy 100 shares for $90 each, and the contract is currently trading at $9.50 per contract ($950 for one contract because the stock option multiplier is 100).

  • XYZ is currently trading at $99.00.
  • You have an XYZ Oct 90 call option.
  • Each call option gives the right to buy 100 shares at the exercise price.
  • The XYZ Oct 90 call option is priced at $9.50.
  • October expiry is in two weeks.

1. Time value

A number of factors determine the value of an option, including the time remaining until expiration and the relationship between the strike price and the stock price. If, for example, one contract expires in two weeks and another contract, on the same stock and the same strike price, expires in six months, the option with six months to life will be worth more than the one with only two weeks. It has more time value remaining.

If a stock is trading at $99 and the October 90 call is trading at $9.50, as in the example, the contract is $9 in the money, which means the shares can be called for $90 and sold for $99, to make a profit of $9 per share. The option has $9 off intrinsic value and has an additional time value of 50 cents if it trades at $9.50. An out-of-the-money contract (say an October 100 call) only includes time value.

It rarely makes sense to exercise an option that has a remaining time value because that time value is lost. For example, it would be better to sell the October 90 call at $9.50 rather than exercise the contract (call the stock at $90 and then sell it back 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 is $950 in option premium. In other words, the investor leaves $50 on the table by exercising the option rather than selling it.

Moreover, it is rarely wise to exercise a out of the money Contract. For example, if the investor is long on the October 100 call and the stock is $99, there is no reason to exercise the October 100 call and buy shares for 100 $ when the market price is $99.

2. Increased Risks

When you hold the call option, the maximum you can lose is the value of the option or $950 on the October 90 XYZ call. If the stock rallies, you still have the right to pay $90 per share, and the value of the call option will increase. You don’t have to own the stock to profit from a price increase, and you don’t lose anything by continuing to hold the call option. If you decide to hold the shares (instead of the call option) and exercise them, you are effectively selling your option at zero and buying the stock at $90 per share.

Suppose a week has passed and the company makes an unexpected announcement. The market doesn’t like the news and the stock drops to $83. It is sad. If you own the call option, it’s lost a lot, maybe nearly worthless, and your account could drop $950. However, if you exercised the option and held shares before the fall, your account value decreased by $1,600, or the difference between $9,900 and $8,300. It’s less than ideal because you’ve lost another $650.

3. Transaction costs

When you sell an option, you usually pay a commission. When you exercise an option, you generally pay an exercise fee and a second commission to buy or sell the stock. This combination is likely to cost more than just selling the option, and there is no need to give the broker more money when you earn nothing from the trade. (However, costs vary and some brokers now offer commission-free trades – 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 shares by exercising it, you now own the shares. You must use cash that will no longer earn interest to fund the transaction, or borrow money from your broker and pay interest on the margin loan. In either case, you lose money with no compensating gain. Instead, just hold or sell the option and avoid additional expense.

Options are subject to automatic exercise at expiration, which means that any contract that is in the money at expiration will be exercised, in accordance with the rules of the Options Clearing Corporation.

Two exceptions

Sometimes an action pays off dividend and exercising a call option to capture the dividend can be interesting. Or, if you have an option that is deep in the moneyyou may not be able to sell it to just value. Whether auction are too low, however, it may be better to exercise the option to buy or sell the stock. Do the math.

The essential

There are good reasons not to exercise an option before and within the expiration date. In fact, unless you want to hold a position in the underlying stock, it’s often a mistake to exercise an option rather than sell it. If the contract is in the money before expiration and you don’t want it to be exercised, be sure to close it with an offset sale, otherwise the contract will be automatically exercised according to the rules of the Options Clearing Corporation.

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