If you are looking for an alternative to just buying and selling stocks, it might be time to consider options trading. What is an option? It is a contract that gives the buyer the right to buy or sell a stock at a predetermined price by a predetermined date.

Keep in mind that the owner of the options contract is not obligated to buy or sell those stocks. In the wild world of options trading, this is called exercising an option. It is one of three possible outcomes of owning an options contract. 

Every options contract has a predetermined price, or a strike price, and the predetermined date, or the expiration date. These two pieces of data dictate how much the option’s premium, or cost of the options contract, will be.

Finally, when exercised, an options contract will provide you with 100 shares of the underlying stock. Are you following along so far? Here are a few of the key terms to help you understand the rest of the article!

The more you know, the better trader you’ll be.

Strike Price

The predetermined price that the options contract may be bought or sold at. The strike price can be in the money, out of the money, or at the money. 

• In the money means that the strike price is lower than the current market value of the stock.
• At the money means that the strike price is about equal to the current market value of the stock.
• Out of the money means that the strike price is higher than the current market value of the stock. 

By default, in the money strike prices are more expensive as they currently carry an intrinsic value. Theoretically, you can buy an in the money stock and exercise it at any time to control those shares. The strike price is key in determining how much you will pay for each contract. 

Expiration Date

This is the predetermined date at which the options contract expires. At the time of expiry, investors have three options for what to do next:

1. Exercise the option and take control of the shares for each contract.
2. Sell the contract to receive the premium or current value of the contract or Closing out the Position. 
3. The contract expires worthless as it has not met the strike price. 

There is a strategy with choosing the right expiration date for your options contract. Long-term investors looking for shares at a lower price will look for a further expiration date.

Short-term traders who are looking to play lotto trades will look for the shortest available expiration date, usually weeklies. 

Premium

The premium is loosely interpreted as the value of the options contract. This can change rather quickly with time decay and the movement of the underlying stock. The premium is the amount you pay to take ownership of the contract, and is also the profit you make if you sell the contract. There are traders who strictly trade options contracts to sell them for the premium to generate steady income. 

Calls vs Puts

Even though there are countless strategies to trading options, there are only two different kinds: calls and puts. A call option is bought when the trader believes the underlying asset’s price will rise in the future. Therefore a put option is bought, then subsequently sold, when the trader believes the underlying asset’s price will fall in the future. Traders can buy or sell both calls and puts, and each different transaction provides a slightly different strategy. 

What does it mean to Exercise an Option?

Exercising an options contract means that the trader is essentially going to trade in the contract for their 100 shares. For North American traders, this can be carried out at any time.

As long as the underlying asset is at or above the strike price, the contract can be exercised. For most brokerages, you will need to call in to get the contract exercised before the expiration date. 

When you are exercising an option, it really depends on what type of options contract you have. If you exercise a call option, it means you are taking ownership of those shares by buying them at a lower price.

If you exercise a put option, it means you are able to sell those shares at a higher price. Either way will lead to a profitable trade for the investor.

You might be wondering what happens to the shares if you exercise an option without having adequate funds in your account. Well, nothing! If you have a margin account there is a chance the brokerage will automatically withdraw the funds to pay for the shares.

But if you have enough funds to cover the cost of buying 100 shares, then you can apply to exercise the shares. Alternatively at most brokerages these days, you can simply leave the options contract until its expiration date. At this point, the bank will automatically draw those funds from your account to pay for the transaction. 

Can I Exercise an Option at any time?

You can exercise at any time as long as the current price of the stock is higher than the strike price for a call option and lower than the strike price for a put option. You also need to have the funds available in your account or have enough margin to borrow from. If these criteria have been met, then feel free to contact your brokerage at any time before the expiration date to exercise the contract. 

US Options Contracts vs. European Options Contracts

I was as shocked as you are when I found out that options contracts are not treated the same around the world. Obviously we are accustomed to the rules and regulations that surround a US options contract. What could be so different about an options contract in Europe? There is really only one critical difference between the two types of options contracts. In the US, you have the ability to exercise the option at any time. In Europe, the trader cannot exercise the option until the expiration date. 

This takes a lot of the strategy out of trading options contracts. Because of these stricter regulations, options contracts have never gained popularity across the pond. A majority of European contracts expire on the third Friday of every month. This is similar to the OPEX Week or Options Expiry Week that we see in the US. Traditionally during these weeks the US markets see a bit more volatility, and the price action of the stocks varies. 

Other Factors to Consider Before Exercising an Option

Now assuming you have the proper amount of funds available to exercise a contract, there are a few other things to worry about. First are the tax implications of buying and selling such a large block of shares.

Keep in mind that since you are exercising at a profit, this will be counted as capital gains and you will be taxed on it. In the US it will be short-term capital gains which are taxed at a higher rate. 

Second, if you are in a share ownership plan with your company, you might find that your shares are vested. This simply means that you must wait a period of time before exercising them. It is a common way of doing things and most CEOs are paid in stock options. 

Finally, this might seem obvious, but make sure you know whether you have a call or a put contract. It makes a difference as one requires buying while the other requires selling shares when a contract is exercised. This can be more important for traders who have a lot of options contract trades on the go.

Is Exercising an Option the Best Thing to Do?

Well, this always depends on your personal investing goals. For long-term investors, exercising an option seems to make the most sense. It provides you with 100 shares of the stock and you can add them to your portfolio once the contract has been exercised. If you are a short-term trader that simply wants to make as much as they can each day, then exercising a contract doesn’t make much sense. You are better off finding the right date to close out the position and sell the contract back for profit. 

Final Thoughts

It should be noted that exercising an options contract is actually the least likely outcome. A majority of traders will close out the position to collect the premium or let the contract expire worthless. A lot of it has to do with the fact that not everyone can afford to pay for 100 shares of a stock when it comes time to exercise the contract. 

Exercising an options contract requires immediate access to enough funds in order to buy 100 shares. If you ever do get to this decision point, know that you bet correctly in the options contract. At least that is one thing to be thankful for! Just remember, if you do choose to exercise the options contract, you are likely to be subjected to a capital gains tax if you sell those shares for a profit. Best of luck trading options! 

If you need more help, take our options trading course.