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The Rules for Exercising Options
04 May, 2018
by Russ Allen

You probably know that a Call option gives you the right to buy a stock at a fixed price; and that a Put option gives you the right to sell a stock at a fixed price. These rights are what give the option its value. When you take advantage of these rights it is called exercising options.

When Should You Exercise Option Calls or Puts?
Under what conditions would one want to exercise the rights the option gives? The answer is that exercising options is almost never beneficial. Only a small fraction of the options that are created are ever exercised, and for good reason.

Does this mean that most option buyers are buying something worthless? Not at all. It just means that there is almost always a more profitable way to close out an option trade than by exercising it.

First let’s look at call options, which give you the right to buy the stock. When you buy a call option, there are three ways that the trade could play out, at your discretion:

  1. You could do nothing with the call, allowing it to expire. In this case you would lose whatever money you had paid for the call.

  2. You could exercise the option call. This means buying the stock and paying the strike price for it. Your total investment would then be the option price paid plus the strike price. This would be profitable if the stock has gone up past your strike price by more than the premium you paid for the call. If the stock is above the strike price by a lesser amount than the premium paid, exercising it will result in a small loss. And if the stock is below the strike price, you would obviously not exercise it, since this would involve paying more than the market price for the stock.

  3. Finally, you could sell the call option before it expires. The option itself has a market value that is constantly changing. It can be sold at any time for its then-current market value. As the stock price goes up or down, the price of the call does the same. You would have a profit if you sold the call for more than you paid for it originally; if you sold it for less you would have a loss.

Of the three choices, 2 and 3 sound similar. In each case you would have either a profit or a loss, depending on the price of the stock at the time we made the decision.

But they are not the same.

Here is an example using options on the stock of Apple:

 Placeholder

Fig 1

Note that at this time the price of the Apple stock was $164.99 (call it $165).

The options shown above were set to expire 22 days after the current date. The call at the 160 strike price was priced at $7.30 (the Bid price).

This call gives the holder the right to buy Apple stock at $160 per share, a $5 discount off the market price of $165. That right would be good for another 22 days. Should it be exercised now?

The answer is No. And that is true regardless of the price originally paid for the option, regardless of whether the holder wants to hold the shares of Apple or not, and regardless of what the holder of the call thinks that Apple will do next. It is just, No.

The reason is pretty clear when you realize that the option itself gives you a discount of only $5, but can be sold for $7.30. If I really wanted to own the Apple shares, I could sell the option for $7.30 per share and then buy the shares at their market value of $165. My net outlay would be $165 – $7.30, or $157.70. This is less than the $160 I would have to pay if I exercised the option.

Why is it that the option is worth $7.30, which is $2.30 more than the $5 discount it provides? Is this normal?

Yes. That additional $2.30 is called time value or extrinsic value. It exists because there is still time left in the option’s life (22 days here), during which the price of Apple could go higher. And the simple fact is that selling any option allows you to collect the time value it contains, while exercising the option means that you are throwing away that time value.

The amount of time value in each option varies, from zero to a huge amount. Knowing the factors that control the amount of time value in options is an important key to option trading, and that’s a much bigger subject than we have space for today. But now you know this much: exercising options that contains time value in them is not recommended. No matter what you want to do with the stock, you are better off to sell the option, and then do the stock transaction.

Russ Allen can be contacted on this link: Russ Allen

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