How to Exercise an Option

Exercising Options Meaning

Do you know how to exercise an option? All the responsibility falls on your broker. Therefore, all you need to do is call your broker and let them know you want to exercise your option, and they’ll take it from there. You can do that at any time you’re holding an options contract. So make sure you’re in a spot where it’s a profitable trade.

Exercising Options Merrill Edge

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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? The contract gives the buyer the right to buy or sell a stock at a predetermined price by a predetermined date.

Remember 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, strike price, and predetermined date or 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 some 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 stock’s current market value.
  • At the money, the strike price is about equal to the stock’s current market value.
  • Out of the money means the strike price exceeds the stock’s current market value. 

In the money strike, prices are more expensive by default 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 determines 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 or Close out the Position. 
  3. The contract expires worthless as it has not met the strike price. 

There is a strategy for 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 looking to play lotto trades will look for the shortest available expiration date, usually weekly’s.

Premium

The premium is loosely interpreted as the value of the options contract. This can change 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 the profit you make if you sell the contract. Some traders strictly trade options contracts to sell them for a premium to generate steady income. 

Calls vs Puts

Even though there are countless strategies for 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. Therefore,, a put option is bought, then sold, when the trader believes the underlying asset’s price will fall. Traders can buy or sell both calls and puts, and each transaction provides a slightly different strategy. 

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What Does It Mean to Exercise an Option?

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

The contract can be exercised if the underlying asset exceeds the strike price. For most brokerages, you must call in to get the contract exercised before the expiration date. 

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

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

You might wonder what happens to the shares if you exercise an option without 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, you can apply to exercise the shares. Alternatively, you can leave the options contract at most brokerages 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 if the stock’s current price 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 enough funds or enough margin to borrow from. If these criteria have been met, contact your brokerage before expiration to exercise the contract. 

US Options vs. European Contracts

I was as shocked as you are when I learned that options contracts are not treated the same worldwide. We are accustomed to the rules and regulations surrounding a US options contract. What could be so different about an options contract in Europe? There is only one critical difference between the two types of options contracts. In the US, you can exercise the option at any time. In Europe, the trader cannot exercise the option until expiration. 

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 we see in the US. Traditionally, the US markets see a bit more volatility during these weeks, and the price action of the stocks varies. 

Factors of Exercising an Option

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.

Remember that since you are exercising at a profit, this will be counted as capital gains and 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 means that you must wait a period before exercising them. It is a common way of doing things; most CEOs are paid in stock options. 

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Is Exercising an Option Best 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 who wants to make as much as they can each day, exercising a contract doesn’t make much sense. You are better off finding the right date to close the position and sell the contract for profit. 

Final Thoughts: Exercising Options

It should be noted that exercising an options contract is the least likely outcome. Most traders will close out the position to collect the premium or let the contract expire worthless. Much of it concerns 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 to buy 100 shares. If you ever get to this decision point, know that you bet correctly in the options contract. At least, that is one thing to be thankful for! Remember, if you choose to exercise the options contract, you will likely 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.

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