A stock option gives an investor or trader the right to purchase a stock at a certain stated price. This stated price is called the strike price. It does not matter where the actual market price of the shares currently sits.
The relationship between strike price and the current market price of a stock is a major determiner of the option value. If the stock price is above the option strike price, the option is "in-the-money" and exercising it will allow you to buy shares for less than you can on the regular stock exchange. However, if the stock is below the strike price, the option is "out-of-the-money."
If the option is "out-of-the-money," there's no reason to exercise the option because you can buy the shares cheaper on the open market.
Approaching the Expiration Date
An option will have no value if the underlying security is below the strike price (in the case of a call option) at expiration. In this case, the option expires worthless and ceases to exist. When an option is in-the-money and expiration is approaching, you can make one of several different moves. For marketable options, the in-the-money value will be reflected in the option's market price. You can either sell the option to lock in the value or exercise the option to buy the shares.
If your option is in-the-money at expiration, your broker will automatically exercise them, and you'll have the shares in your brokerage account on Monday morning; for employee stock options, you must exercise in-the-money options before they expire.
Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might limit your loss. For example, if you buy a call option for stock A, which currently trades at $90, a decision has to be made as to whether to exercise the option at its expiration date, sell the option or let the option expire. Let's say the stock price goes up to $100 and the option cost is $2. If a decision is made to exercise the option, then the profit that would be made is $100-$90-$2 = $8.
Timing is Everything
It is important to remember that some types of options permit the holder to exercise the option at specific times. An American-style option has no restriction. It can be exercised at any time between the purchase date and the expiration date. A European-style option, however, can only be exercised at expiration and Bermuda options have specific periods when exercise is permitted.
If the decision is made to sell the option, then the profit made may be slightly higher. If the option is sold before expiration date, then implied volatility and the number of days remaining before expiration may increase the price of the option. Let's assume that the price is higher by 10 cents. The profit made will be $10.10 - $2 = $8.10. The decision to sell the option assumes that it is in the money. If the option is out of the money, then exercising the option makes no sense at all because money will be lost if the stock is sold on the market.
Short Positions are Different
One scenario that calls for letting the option expire occurs when you are holding a short position on an option that is out of the money. If you are short a put option that is worth $2, closing the position will cost you $2 plus commission. However, letting the option expire will only cost you $2. In this case, no profit is made, but losses were limited.