Exercise

DEFINITION of 'Exercise'

To put into effect the right specified in a contract. In options trading, the option holder has the right, but not the obligation, to buy or sell the underlying instrument at a specified price on or before a specified date in the future. If the holder decides to buy or sell the underlying instrument (rather than allowing the contract to expire worthless or closing out the position), he or she will exercise the option, and make use of the right available in the contract.

BREAKING DOWN 'Exercise'

In options trading, the buyer (or holder) of a call contract may exercise his or her right to buy the underlying shares at the specified price (the strike price); the buyer of a put contract may exercise his or her right to sell the underlying shares at the agreed-upon price. If the buyer chooses to exercise the option, he or she must inform the option seller (the writer of the option contract). This is achieved through an exercise notice, the broker's notification that a client wishes to exercise his or her right to buy or sell the underlying security. The exercise notice is forwarded to the option seller via the Options Clearing Corporation. Even though the buyer has the right but not the obligation to exercise the option, the seller is obligated to fulfill the terms of the contract if the buyer decides to exercise the option.

The majority of options contracts are not exercised, but instead are allowed to expire worthless or are closed by opposing positions. For example, an option holder can close out a long call or put prior to expiration by selling it (assuming the contract has market value). If an option expires unexercised, the holder no longer has any of the rights granted in the contract. In addition, the holder loses the premium that was paid for the option, along with any commissions and fees related to its purchase.

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