When newcomers to the options universe get started, they all learn, and probably memorize, the definition of an option:
|A call option is a contract that grants its owner the right, but not the obligation, to buy 100 shares of the underlying asset by paying the strike price per share – for a limited time. Similarly, a put option grants the right to sell.|
The concept seems easy, yet I've received too many questions on this topic from people who have difficulty grasping the entire picture. It's my hope that this basic discussion will turn this concept from puzzling to obvious.
Right Vs. Obligation
An option owner has the right to exercise. If you own an option you are NOT obligated to exercise; it's your choice. As it turns out, there are good reasons not to exercise your rights as an option owner. Selling the option is usually the best choice for an option owner who no longer wants to hold the position.
An option seller has obligations – which he/she may be called upon to fulfill. The obligation of a call seller is to deliver 100 shares at the strike price, but only if the option owner exercises his/her right before the option expires. The obligation of a put seller is to purchase 100 shares at the strike price, but only if the option owner exercises before the option expires.
If called upon to fulfill the conditions of the option contract by its owner, the option seller must honor the contract. In fact, the process is automated and guaranteed. There is no possibility that the contract will not be honored. The seller is informed (in the morning) that last night, when the markets were closed, the transaction occurred. Thus, 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. (To learn more, see The Basics Of Buying Options.)
When is it wrong to exercise?
This discussion is easier to follow when we use an example. Let's take the following as given:
- JKLM is currently trading at $99.00
- You own one JKLM Oct 90 call option
- The JKLM Oct 90 call option is priced at $9.50
- October expiration arrives in two weeks
- Increased Risk
Exercising this call option prior to expiration increases risk. But to make it even worse, you have nothing to gain for taking on that added risk.
When you own the call option, the most you can lose - from today, it does not matter what price you paid to buy this option earlier - is the value of the option, or $950. If the stock rallies, you still own the right to pay $90 per share for JKLM. It is not necessary to own the shares to profit from a price increase. You lose nothing by continuing to hold the call option.
If you decide you must own the shares (instead of the call option) and exercise, you effectively sell your option at zero (because it has been used) and buy stock at $90 per share. Let's assume that one week passes and the company makes an unexpected announcement. The market does not like the news and the stock opens for trading at $85 and soon sinks to $83. That's unfortunate. If you own the call option, it has become almost worthless. Your account is worth $950 less than it was just one week ago.
But, if you exercised your option and own stock, your account value has decreased by $1,600, or the difference between $9,900 and $8,300. This is an unacceptable loss. There was never any chance to gain by exercising the call option, and although you were unlucky, you lost an additional $650 by exercising. Yes, by exercising. If you still owned the option, you would have fared better.
To clarify any misconceptions: If you wanted to take your profit, you could have sold your option earlier. The decision 'not to exercise' did NOT force you to hold onto the option and then incur a loss. It's important to understand that most people who exercise a call option do not want to invest in the stock. Instead, they exercise and then sell the shares. There is no need to do that. Just sell the option instead. (For more, read Using Options Instead Of Equity.)
- Extra Commissions
When you sell the option, you pay a commission. When you exercise an option, you (with most brokers) pay a fee to exercise. Then you pay another commission to sell the shares. This combination probably costs more (be certain you understand your broker's fee and commission schedule) than simply selling the call. There is no need to give your broker a bonus when there is nothing in it for you.
- Extra Interest Costs
When you buy an option, you pay for it. There are no additional costs to hold the position. When you convert that option into stock by exercising, you now own the shares. You must use cash – which will no longer be earning interest – or borrow cash from your broker – and pay interest on that loan. In either case, you are accruing interest charges, with no offsetting gains. There is no benefit to be derived by owning stock. Just hold (or sell) the call option and don't pay additional expenses.
- Trading on Margin
If you trade on margin, the requirement is greater when you own stock as compared with owning call options. This may not be true for low-priced stocks.
Occasionally the stock pays a big dividend and exercising a call option to capture that dividend may be worthwhile.
If you own an option that is deep in the money, you may not be able to sell it at its fair value. If the bids are too low, it's preferable to exercise the option then immediately unload the stock position. This is not a common occurrence.
There are solid reasons for not exercising an option before expiration arrives. Each of those reasons also applies at expiration. Unless you want to own a position in the underlying stock, it is almost always wrong to exercise an option when you can sell it instead.
To learn more, see our Options Basics Tutorial.