5. How to Exercise Stock Options?

What is exercise？    

Investors in stock option contracts have the right to buy or sell underlying stocks at a predetermined price within a specific time period. If the option holder decides not to buy or sell the underlying shares, they can close the position or let the option expire. However, when an investor decides they want to take action on their right to buy or sell, it’s called exercise. Exercising a stock option means that a trader buys or sells the underlying stock associated with the options contract at a price set by the contract, which is called the strike price. Before exercising an option, it is important to consider what option you have and whether you can exercise it. 

• Exercising call options

Exercising a call option allows you to buy the underlying security at a stated price within a specific timeframe. If you own a call option and the stock price is higher than the strike price, then it makes sense for you to exercise your call because you can buy the stock at a lower price and immediately sell it to the market at a higher price or hold onto it for a long term.

• Exercising put options

Exercising a put option allows you to sell the underlying security at a stated price within a specific timeframe. If you own a put option and the stock price is lower than the strike price, then it makes sense for you to exercise it because you can sell the stock at a higher price and immediately buy it back at the lower price.

If an option expires unexercised, the holder no longer has any of the rights granted in the contract. Also, the holder loses the premium they paid for the option, along with any commissions and fees related to its purchase.

When should investors exercise stock options?

The holder of an American-style option can exercise their right to buy or sell the underlying shares of stock at any time. The holder of a European-style option can only exercise their right at expiration.

Most options expire worthless, or out of the money so exercising them wouldn’t make sense. However, if your options are at or in the money and you want to buy or sell the underlying, then exercising them would be appropriate. Here are three situations in which you may want to exercise your options: 

• When the call option is in-the-money
  Investors can choose to exercise the call option if it is in the money, meaning the strike price is lower than the current stock price. For example, if the strike price is $90 and the stock price is $100, exercising would not make you money because you can purchase the stock for $10 less than the strike price.
• When you want to hedge a short sale
  You can exercise a call option if you are using it to hedge a short stock position when the price of the stock continues to increase. A short stock position involves selling shares that you borrow from your brokerage firm in the hope that you can buy the shares back at lower prices. If the stock price rises instead, you can use a call option with the appropriate strike price to prevent losses because you could exercise the calls to hedge your short stock position.
• When the underlying stock is due to pay a dividend
  Another reason for exercising could be if you hold a call option that is based on an underlying stock that is set to pay a big dividend, you can exercise, buy the stock, receive your dividend, and then decide whether to sell or hold the stock.

Example of exercising stock options

Let’s say you bought 100 shares of Apple at $150 and you are concerned the price might fall below $120, then you can buy an Apple put option with a strike price of $120. In this case, if the price drops to $100 you will be able to exercise your option and sell your stock for $120. You should note that you don’t have to sell your Apple share at $120 because if the price in the market is $130 then of course you can sell your share at the market price of $130.

How do investors exercise stock options?

Basically, investors must direct their brokerage firm to submit an exercise notice to the Options Clearing Corporation (OCC). Option holders need to ensure that they exercise the option on that particular day, the holders must notify their brokerage firm before that day’s cut-off time for accepting exercise instructions.

The brokerage firm notifies OCC that an option holder wishes to exercise an option. OCC then randomly assigns the exercise notice to a clearing member. Generally, an investor’s brokerage firm is chosen at random from a total pool of such firms. The firm must then assign one of its customers who have written (and not covered) that particular option.

Summary:

• 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 you own a call option and the stock price is higher than the strike price, then it makes sense for you to exercise your call because you can buy the stock at a lower price and immediately sell it to the market at the higher price or hold onto it for a long term.
• If you own a put option and the stock price is lower than the strike price, then it makes sense for you to exercise it because you can sell the stock at a higher price and immediately buy it back at the lower price.
• Investors can exercise a call option if they are using it to hedge a short position when the price of the stock continues to increase.
• If you hold a call option that is based on an underlying stock that is set to pay a dividend, you can exercise, buy the stock, receive your dividend, and then decide whether to sell or hold the stock.

Risk Warning:

Options have a leverage effect, and their value depends on a number of factors, including the price of the underlying asset, volatility, and the time until the contract expires. Therefore, options are subject to significant short-term fluctuations. Option buyers may lose the entire premium paid and the trading costs incurred. At the same time, some option selling strategies may result in losses exceeding the initial investment. Before trading options, you must carefully study the trading rules, assess your own risk tolerance, and make informed decisions.

The materials in this course are intended solely for educational purposes and do not constitute an offer to sell or a solicitation to buy any securities or financial instruments, nor do they express any opinions or constitute investment recommendations regarding such securities, financial instruments, or investment objects.