In earlier chapters, we talked about how options actually work and the various types of options out there. In this chapter, we are going to take a deep dive into exercising options and why you want to exercise it!
As we now know, calls and puts gives the owner of the contract to buy or sell a stock, or underlying asset at a specific price at, or before the maturity date. If the trader has not hit their strike price, that contract is deemed to be worthless, and therefore, they should not have to exercise the option at all. However, if the strike price has been hit, we call the option “in-the-money”. Under such conditions, the owner of the contract can choose to exercise the option to sell the stock to profit or to close the position by selling the contract to another buyer.
If you wish to exercise your option, simply let the broker know of the intent to exercise. Different brokers/trading platforms have different ways to exercise options and it is important that you understand how to operate these platforms before you start with real money trading.
Exercise Call Option
In a nutshell, you should only exercise a call option when the stock price is HIGHER than the strike price. Note that when you are exercising a call option contract, it is important that you have the capital in your bank account to actually purchase the stock. In many brokerages, you can make use of [leverage] to trade on margin, therefore, you only need to have the margin equivalent of capital in your account. As you progress through the course, you will understand the pros and cons of trading on a margin.
Exercise Put Option
Conversely, when the stock price is LOWER than your strike price of a put option, it makes sense to exercise that option. In this way, you can sell the option and buy it back immediately at a lower price specified in the contract. For more information on this concept, check out [shorting a stock.]
When NOT to exercise an Option
In reality, most traders choose NOT to exercise an option simply because it’s more profitable to close a position. When you are in-the-money, the demand for your options increase because everybody believes that you will remain in-the-money and that your options’ value is going to go higher. This pumps up the cost of your premium and more often than not, you can make more money by selling your options to another buyer than exercising the options to sell the shares.
Of course, take note that the value of the options is also affected by the time value. The closer the option is to expiration, the less valuable it will be. Therefore, the ideal time to close an options position is when there is a lot of time left on the contract and that the price of the underlying shares has undergone a spike in value.
In short, the model for calculating the value of an option consists of the price per share, the time period left on the stock as well as the volatility of the underlying stock. The mathematics behind it rather complicated and for now, scratching the surface is enough! In the next chapter, we will go a little deeper in understanding the factors that affects options valuation.
How To Trade Options
Why Trade Options?
Calls and Puts
How Options Work
Types of Options Orders
Valuation of Options
Choosing The Best Options Broker
Leverage in Trading Options
Mistakes Options Traders Make