In order to become successful in the options market you must first understand the rights and obligations associated with these trading vehicles. As with most contracts, the devil’s in the details. And if you avoid learning the details of option contracts, the devil will steal your money.
So let’s save ourselves some financial capability pain by taking a moment to learn one important dynamic of option contracts: exercise. We’ll use a call option to illustrate. Let’s begin by reminding ourselves of the definition of a call option:
A call option gives the buyer the right, but not the obligation, to buy 100 shares of stock at a specific price (strike price) on or before the expiration date.
When a call buyer decides to utilize their right to buy 100 shares of stock at the strike price they are exercising the call option. Suppose you bought a December 100 strike call option on AAPL for $500. If you exercised the call you would purchase 100 shares of stock at $100 for a total cost of $10,000. Exercising essentially allows you to turn your option into a stock position.
Now, should we exercise options?
Rather than exercising options to buy stock, the better route is to simply sell the option to close the position, and then buy stock separately if you’re intent on owning shares.
There are 3 primary reasons why exercising is a bad idea.
- It costs a lot of money. In the AAPL call option example, we only had to pay $500 to own the call option. If we exercised and bought 100 shares of stock it required $10,000 of capital.
- It completely changes your risk profile. With the AAPL call option, we only had $500 of risk. By exercising and buying 100 shares of stock our risk ramped up to a whopping $10,000.
- When you exercise the option you lose any remaining time value in the premium. The better route is to simply sell the option contract to capture the time value.
Just because options give you the right to buy or sell a stock doesn’t mean you should. We buy options in hopes of selling them later at a higher price, not with the intent of exercising them.
- Jonas Taylor is a financial expert and experienced writer with a focus on finance news, accounting software, and related topics. He has a talent for explaining complex financial concepts in an accessible way and has published high-quality content in various publications. He is dedicated to delivering valuable information to readers, staying up-to-date with financial news and trends, and sharing his expertise with others.