When newcomers enter the options universe for the first time, they learn and probably memorize definitions for major 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 asset by paying the strike price per share, up to the expiration date. Conversely, a put option grants a similar right to sell. These concepts seem easy yet many folks have difficulty grasping the entire picture. Hopefully, this basic discussion will turn these concepts from puzzling to obvious.
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Right to Exercise An Option
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. Instead, selling the option is usually the best choice for an option owner who no longer wants to hold the position.
Obligations to An Option
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 his/her right before the option expires.
The option seller must honor the contract if called upon to fulfill the conditions by the option owner. The process is automated, guaranteed and the seller is informed when the transaction took place. 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.)
Four Reasons To Hold and Not Exercise An Option
Consider the following example:
- XYZ is currently trading at $99.00
- You own one XYZ Oct 90 call option
- The XYZ Oct 90 call option is priced at $9.50
- October expiration arrives in two weeks
1.) Increased Risk
Exercising this call option prior to expiration increases risk. More importantly, you gain nothing by taking on added risk.
When you own the call option, the most you can lose is the value of the option, or $950. If the stock rallies, you still own the right to pay $90 per share. It is not necessary to own the shares to profit from a price increase and you lose nothing by continuing to hold the call option. If you decide you want to own the shares (instead of the call option) and exercise, you effectively sell your option at zero and buy stock at $90 per share.
Let's assume 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 sinks to $83. That's unfortunate. If you own the call option, it has become almost worthless and your account has dropped by $950. However, if you exercised the 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 because there was never a chance to gain by exercising the call option and, although you were unlucky, you lost an additional $650.
To clarify misconceptions: you could have sold your option earlier if you wanted to take your profit. The decision 'not to exercise' didn't force you to hold the option and 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 because it makes more sense to just sell the option. (For more, read Using Options Instead Of Equity.)
2.) Extra Commissions
When you sell the option, you pay a commission. When you exercise an option, you usually pay a fee to exercise and a second commission to sell the shares. This combination is likely to cost more than simply selling the option. There is no need to give the broker more money when you gain nothing from the transaction.
3.) Higher Transaction Fees
When you buy an option, you pay for it and you're done. There are no additional costs to hold the position. When you convert the option into stock by exercising, you now own the shares. You must use cash that will no longer be earning interest to fund the transaction, or borrow cash from your broker and pay interest on the margin loan. In both cases, you are losing money with no offsetting gain. Instead, just hold or sell the option and avoid additional expenses.
4.) Higher Margin Exposure
The brokerage account will hold less free capital after exercising an option, often forcing the account holder to use greater margin and incur higher lending costs.
1. Occasionally the stock pays a big dividend and exercising a call option to capture the dividend may be worthwhile.
2. If you own an option that is deep in the money, you may not be able to sell it at fair value. If bids are too low, it may be preferable to exercise the option and immediately unload the stock. This is not a common occurrence.
The Bottom Line
There are solid reasons for not exercising an option before and into the expiration date. So, unless you want to own a position in the underlying stock, it is usually wrong to exercise an option rather than selling it.
To learn more, see our Options Basics Tutorial.