A stock option gives the holder the right (though not an obligation) to buy or sell a stock at a specified price. This stated price is called the strike price. The option can be exercised any time before expiry, regardless of whether the strike price has been reached.

The relationship between an option's strike price and the market price of its underlying shares is a major determinant of the option's value. In the case of call options, if the stock trades above the strike price the option is in the money. Exercising the call option will allow you to buy shares for less than the prevailing market price. However, if the stock trades below the strike price, the call option is out of the money. It would make little sense to exercise the call when better prices for the stock are available in the open market.

If you hold an out-of-the-money call, there's no reason to exercise the option, because you can buy the underlying shares cheaper on the open market.

Approaching the Expiration Date

A call option has no value if the underlying security trades below the strike price at expiry. A put option, which gives the holder the right to sell a stock at a specified price, has no value if the underlying security trades above the strike at expiry.

In either case, the option expires worthless. When an option is in the money and expiration is approaching, you can make one of several moves. For marketable options, the in-the-money value will be reflected in the option's market price. You can sell the option to lock in the value, or exercise the option to buy the shares (if holding calls) or sell the shares (if holding puts).

Check with your broker to see how in-the-money options are handled at expiration. A broker such as Fidelity may automatically exercise in-the-money options on your behalf unless instructed not to do so.

The Rules

As an option approaches expiry, there are three choices to be made: sell the option, exercise the option, or let the expiration expire. Out-of-the-money options expire worthless. In-the-money options can exercised or sold.

For example, a trader pays $2 for a $90 call option on Company XYZ. Because one options contract represents 100 shares, the trader pays $200 for this investment. At expiry, Company XYZ trades for $100 in the open market and the call option is priced at intrinsic value, meaning the trader can now sell the option for $10 ($100 market price - $90 strike price). The trader's profit is $800, or ($10 x 100 shares = $1,000 - $200 initial investment).

The trader can also decide to exercise the option and hold shares in Company XYZ. To do so, they must pay $9,000 ($90 exercise price x 100 shares = $9,000). In this scenario, the trader has made a paper profit of $800 ($10,000 market price - $9,000 cost basis - $200 for the call option).

Timing Is Everything

It is important to remember that some types of options must be exercised at specific times. An American-style option can be exercised any time between purchase and expiry. However, European options can only be exercised at expiry. Bermuda options can be exercised on specific dates as well as expiry.

A trader can decide to sell an option before expiry if they believe this would be more profitable. This is because options have time value, which is the portion of an option's premium attributable to the remaining time until the contract expires.

Let's return to our example above. A trader pays $2 for a $90 call option on Company XYZ, for a total outlay of $200. The stock climbs and Company XYZ now trades for $100. Let's say the $90 call options fetch $12 each, with one week left until expiry. Of this, $10 is intrinsic value ($100 market price - $90 exercise price). The remaining $2 is time value, which is the market's way of saying it believes Company XYZ can climb another $2 in the time left before the option expires.

If the trader exercises the option, the paper profit is $800 (same as above). However, if the trader sells the option, the profit is $1,000 (or $1,200 - $200).