You may have heard that trading stock options can be worth a lot of money when used correctly, and it is certainly true.
But do you really know how stock options work? Or what a stock option is? Do you know what it mean to exercise options?
If you are curious, here is a rundown of the basics of stock options trading.
How do Options Work?
Before we explain what exercise stock options means, you need to understand stock options and how they work on a basic level.
What is a Stock Option?
A stock option is a financial contract that gives the buyer the right to buy or sell an underlying stock at a predetermined price (strike price) before a certain expiration date.
Keep in mind that a buyer of a stock option is a right, not an obligation, to buy the stock, meaning that the option holder may choose to not exercise the option.
Stock options can be bought on many available stocks through a brokerage firm. Some companies also give their employees stock options: the opportunity to buy shares of the company after a set amount of time known as the “vesting period.”
What Does it Mean to Exercise Options?
To “exercise options” simply means that the holder chooses to buy or sell shares of stock per the stock option agreement. Should you choose to enforce you right under the terms of the stock options contract, you are said to be exercising your option.
If you do have stock options that you would like to exercise, the process is actually relatively easy; all you have to do is ask your brokerage firm to exercise them on your behalf OR let them expire in the money and they will automatically be exercised.
If you are using an online brokerage, it is usually an easy process of clicking a button in the trading platform. Your brokerage will then finish the necessary steps need to complete the exercise.
Difference Between Exercising Calls and Puts
You can buy or sell two different types of options: calls and puts.
A call option is a contract that gives the option holder the right, but not the obligation, to buy a specified number of shares of a specific stock at a specific price (strike price) by an expiration date.
A call buyer profits when the underlying stock increases in price.
A put option is a contract that gives its holder the right, but not the obligation, to sell a specified number of shares of a specific stock at a specific price (strike price) prior to its expiration date.
If a put option is exercised, the writer of the option contract is obligated to purchase the shares from the option holder.
With a put stock option, you pay a fee for the right to sell a stock at the strike price by the option expiration date.
A put option increases in value as the price of the underlying stock decreases.
What Happens if you don’t Exercise Your Options?
Options become worthless when they hit their expiration date and they trade below their strike price. The closer an option nears its expiration day, the faster it loses value.
To protect your trading capital, exercise your options and take your profit or loss prior to the expiration date.
Monthly options expire the third Friday of each month, while weekly options expire every Friday. It should also be noted that options trading can be unpredictable and volatile on expiration day.
When Should you Exercise Your Options?
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.
When the call option is “in the money”
You can choose to exercise your call option if it is “in the money,” meaning the strike price is lower than the stock price.
For example, if the strike price is $30 and the stock price is $20, 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 also exercise a call option if you are using it to hedge a short stock position and 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 share-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 dividend. You can exercise, buy the stock, receive your dividend, and then decide whether to sell or hold the stock.
Another common reason for exercising is when a trader owns call options based on an underlying stock and they decide they actually want to own that
Exercising Call Options
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.
This way 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 long term.
Exercising Put Options
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.
This way you can sell the stock at a higher price and immediately buy it back at the lower price.
Example of exercising your options
If you bought a 100 shares of Tesla (NASDAQ: TSLA) at $420 and you are concerned the price might fall below $350, you can buy a TSLA put option with a strike price of $350.
That way if the price drops to $300 you will be able to exercise your option and sell your stock for $350.
Please note that you don’t have to sell your TSLA shares at $350! If the price in the market is $375 then of course you can sell your shares in the market at $375.
That is why it is called an option – it is an option and not an obligation.
Stock options have long scared many traders due to how complicated they can be, but they are still widely used to speculate on market prices and portfolio hedging.
Puts and calls, when understood and used properly, can help increase returns and balance risk.
Traders ought to use them in conjunction with portfolio theory to minimize the risk of owning stock ownership, and overall portfolio volatility.
Remember to always try and determine what course of action gives you the best result when exercising stock options, and be aware of the potential disadvantages of doing so.