What Does Exercise Mean?
Exercise means to put into effect the right to buy or sell the underlying financial instrument specified in an options contract. In options trading, the holder of an option has the right, but not the obligation, to buy or sell the option's underlying security at a specified price on or before a specified date in the future.
If the owner of an option decides to buy or sell the underlying instrument—instead of allowing the contract to expire, worthless or closing out the position—they will be "exercising the option," or making use of the right, or privilege that is available in the contract.
The decision to exercise an option isn't always a clear-cut one. There are several factors that need to be considered before making the decision; however, more often than not, it's safer to hold or sell the option instead.
Exercising Put and Call Options
An options holder may exercise his or her right to buy or sell the contract's underlying shares at a specified price—also called the strike price.
- Exercising a put option allows you to sell the underlying security at a stated price within a specific timeframe.
- Exercising a call option allows you to buy the underlying security at a stated price within a specific timeframe.
To exercise an option, you simply advise your broker that you wish to exercise the option in your contract. Your broker will initiate an exercise notice, which informs the seller, or writer of the contract that you are exercising the option. The notice is forwarded to the option seller via the Options Clearing Corporation. The seller is obligated to fulfill the terms of an options contract if the holder exercises the contract.
- In options trading, "to exercise" means to put into effect the right to buy or sell the underlying security that is specified in the options contract.
- If the holder of a put option exercises the contract, then he will sell the underlying security at a stated price within a specific timeframe.
- If the holder of a call option exercises the contract, then she will buy the underlying security at a stated price within a specific timeframe.
- Before exercising an option, it is important to consider what type of option you have and whether you can exercise it.
The majority of options contracts are not exercised but, instead, are allowed to expire, worthless, or are closed by opposing positions. For example, the holder of an option 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 he or she paid for the option, along with any commissions and fees related to its purchase.
Things to Consider When Exercising an Option
- What kind of option do you have? This is very important, as contracts have different guidelines. American-style contracts allow you to exercise them before their expiration date. European options may be exercised only after the contract has expired.
- Can you exercise your options? In some cases, such as employee stock ownership plans (ESOPs), your shares may be vested, meaning that you will need to wait a set amount of time before you exercise the option.
- Will the cost outweigh the benefits? Exercising a contract costs you commission money, so make sure that the exercise price will make you money; otherwise, you'll end up paying more in fees and you will lose out on any potential profit.
- Are there taxes involved? You will want to consider any tax implications associated with the type of contract you are exercising because, for example, an employee cashing out an ESOP will have to pay additional tax.