Options are bought and sold by traders before expiration. If you are a newbie investor, you might feel the urge to avoid this as it seems to risk inviting. But who wants options that have expired?
What does it mean to exercise an option?
“Exercise an option” means that if you hold of a put option, you can sell a security at a stated price within a particular timeframe, or if you control a call option, you can buy a security at a stated price within a specific timeframe.
These options are not often exercised because the traders choose to close them and complete the steps before they expire. Of course, options can be exercised, but that is not mandatory. Instead, close the options and earn profits, which most people in the market do.
But how would you find the right time to close or exercise options? Let’s find out through this article.
What happens when you exercise a call option?
Suppose you have a call option contract that may give you as a holder the right to buy X shares of some stock at $Y up until some expiration date. For example, if the strike price is less than the stock price, you may exercise a call option.
Is it better to exercise an option or sell it?
Usually, it is better to sell options through an offsetting transaction rather than an exercise option. This is because you pay a second commission to buy or sell the shares when exercising the option.
How long does it take to exercise an option?
Usually, an early exercise request will be submitted immediately if early exercise is placed during trading hours between 9 AM ET and 4 PM ET for the US market. However, if you submit early exercise requests after 4 PM ET, you will need to wait to be queued for the next trading day.
Why do traders not exercise their options?
There is no obligation to exercise options, and hence the traders do not feel the requirement to do it. In most cases, the trader will sell the option by offsetting the transaction. As a result, they earn profits and no longer possess an option they do not want.
Can you exercise an option at any time?
Yes, you can exercise options at any time, but only if you use American option contracts. So, some brokers allow, and some do not. However, the holder of a European-style option can only exercise options at expiration.
Meaning of right to exercise
Newbie investors in the market need to know that they have the power to exercise the options, and they don’t need to purchase or buy. For example, if you have a call contract, you can get a hundred shares of the stock and sell them as you please.
However, you are not obligated to make this move.
Finance books point out that exercising means you have the right to purchase or sell the shares in a contract that you acquire. However, knowing the correct chance to exercise your option can be a predicament. Several factors go into consideration, including the time before it expires.
In several cases, investors close the option. If you have options, its value will increase in the future. If you exercise these options, you will become devoid of profits; hence, exercising it is not favorable for many investors.
It would help if you understood that exercising puts and calls are different. Calls enable you to purchase, while puts allow you to sell. In case of a put, you have to pay a fee and buy the stocks from the person holding them.
Reasons not to exercise options.
Some compelling reasons exist as to why one shouldn’t exercise the option. However, the main factor in making money and forfeiting is more than your investment. Here is what you should consider before indulging in trade:
Value raises with time
The time preceding the expiry date will significantly affect the options’ value. Additionally, the share price and strike price should be in a particular range to earn profits.
As time passes, more value is added to the security attached to the contract. For instance, if you have an option with expiration after one week with a stock expiring after three months. In such a case, the stock with three months to expire is more valuable. This is also called time value in investing.
Hence, the options with late expiration dates have a high value because the value increases before they expire.
To find the value of time, you can use the following formula: Subtract the intrinsic value from the option premium. The premium adds time to value and face value together. Hence, if your option has a high time value, you will not profit.
There are risks if you exercise it.
You will face risks if you decide to go with the option of exercising the option you have. For example, if you possess a call option, there will be a loss to the options’ value. However, as you exercise it, you can face significant losses about the volatile prices for the shares that you purchase.
In the case of options trading, you are not the direct owner of the shares in the options, and you can earn profits. Hence, exercising is just an additional. Hence, holding the options is the sensible choice. This is a safer choice than exercising your shares.
Low cost of a transaction
If you have selling options, you also have to pay a commission. While selling an option, you are obliged to pay a commission or fee to sell it. Hence, it takes your money rather than providing benefits.
When you are not getting any profits from a trade, what’s the use in selling it? However, brokers are not the same. Hence, it would help if you recovered the truth on your own.
What are margin loans?
At last, if you are not equipped with a good amount for the exercising cost of an option, you will have to take a margin loan at the time of converting a call into shares. You will not become the stock owner without any pay or interest on the money you invest. To top it off, you will always be paying a fee to your broker.
Margin loans are created by brokers that allow investors to take money or borrow for purchasing securities. Options are contracts that give you the right to sell. You are not paying the total price while buying it, but you need to do so if you exercise the option.
These loans engulf your profit when you exercise your option.
Rare occasions when options are exercised
There are few instances where options are exercised. For example, if the stocks pay a lot of profits in profits/ dividends. You can get those dividends, and paying commissions will be worth it.
There will also be times when your assessment predicts that it is best to take action on options trade to earn profit. In such cases, you should take the chance of exercising your stock. Because if it expires, there will be more significant losses.
The most reasonable thing to exercise stock is when you desire to become the owner of the stock. Since everyone rarely exercises their options, it is justifiable for investors to go this route.
To know more, the options course workbook by George A. Fontanills will provide you with in-depth knowledge about exercising options for trading better. Hence, it would help if you first learned before you start investing.
How to exercise a call option on Robinhood?
To exercise a call option on Robinhood, you just need to navigate the options position detail screen and click “Excercise.” Then, the app will ask you to tell why you exercised options.
Final thoughts
The option to exercise is something that not many people prefer to do if they want to earn profits. They close the contract by offsetting the sale, which is a much better option. It would help if you kept tracking the expiration date lest you want to lose all your money.
Options are tedious to invest in, but you can turn them into a very profitable avenue with proffered knowledge and skills. Hence, educate before you dive into the options world.
He is an expert in financial niche, long-term trading, and weekly technical levels.
The primary field of Igor's research is the application of machine learning in algorithmic trading.
Education: Computer Engineering and Ph.D. in machine learning.
Igor regularly publishes trading-related videos on the Fxigor Youtube channel.
To contact Igor write on:
igor@forex.in.rs
