What Does Exercise Mean?

To exercise means 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.

The Basics of Exercising

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 – also called the strike price. The way in which you exercise is fairly simple: advise your broker you wish to exercise your options and he or she will take care of it for you. If you use an online portal, you can click on a button to do the same.

Exercising Put and Call Options

If you decide to exercise a put option, you will sell whatever amount of the underlying security – as long as you own it. If you don't, you may need to buy it before you can exercise the option. As the buyer, you must inform the option seller – the writer of the option contract – you are exercising the option. This is achieved through an exercise notice, the broker's notification that you will exercise your right to buy or sell the underlying security. The notice is forwarded to the option seller via the Options Clearing Corporation. The seller is obligated to fulfill the terms of the contract if the buyer decides to exercise the option.

When an investor exercises a call option, the inverse is true. You will buy a certain amount of the underlying security, after which you can choose to hold or sell it.

Unexercised Options

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.

What to Consider When Exercising an Option

There are a few things investors need to consider before they exercise any options:

  • What kind of option do you have? This is very important, as certain contracts have different guidelines. American-style contracts allow you to exercise them before the date of expiration. European ones can only be done after the contract has expired.
  • Can you exercise your options? In some cases, such as employee stock ownership plans (ESOP), your shares may be vested, meaning you will have to wait a set period of time before you exercise them.
  • Will the cost outweigh the benefits? Exercising a contract costs you (commission) money, so you should make sure that it's worth it. Make sure the exercise price will make you money, or else you'll end up paying more in fees and you'll lose out on any potential profit. You will also want to consider any tax implications associated with the type of contract you're exercising because an employee cashing out an ESOP will have to pay additional tax.

Fast Facts

  • Exercise means putting the right specified in a contract into effect.
  • The buyer or holder of a call contract may exercise the right to buy the underlying shares at the specified price.
  • Before exercising an option, consider what kind of option you have and whether you can exercise it.