What Is Exercise?
Let me explain what exercise means in options trading. It refers to putting into effect the right to buy or sell the underlying financial instrument specified in an options contract. As the holder of an option, you have the right, but not the obligation, to buy or sell the option's underlying security at a specified price on or before a specified date in the future.
Key Takeaways
In options trading, to exercise means to activate the right to buy or sell the underlying security specified in the options contract. You exercise an option by advising your broker that you wish to do so. If you hold a put option and exercise it, you sell the underlying security at a stated price within a specific timeframe. If you hold a call option and exercise it, you buy the underlying security at a stated price within a specific timeframe. Before exercising, consider what type of option you have and whether you can exercise it.
Understanding Exercise
If you as the owner of an option decide to buy or sell the underlying instrument instead of letting the contract expire worthless or closing out the position, you are exercising the option, making use of the right or privilege available in the contract.
You as an options holder may exercise your right to buy or sell the contract's underlying shares at a specified price, also called the strike price. Exercising a put option lets you sell the underlying security at a stated price within a specific timeframe. Exercising a call option lets you buy the underlying security at a stated price within a specific timeframe.
To exercise an option, you simply advise your broker that you wish to exercise the option in your contract. Your broker will initiate an exercise notice, which informs the seller or writer of the contract that you are exercising the option. The notice goes to the option seller via the Options Clearing Corporation (OCC). The seller is obligated to fulfill the terms of the options contract if you exercise it.
The decision to exercise an option isn't always clear-cut. There are several factors to consider, and more often than not, it's safer to hold or sell the option instead. The majority of options contracts are not exercised but are allowed to expire worthless or are closed by opposing positions. For example, you as the holder can close out a long call or put prior to expiration by selling it, assuming it has market value.
If an option expires unexercised, you as the holder no longer have any of the rights granted in the contract. In addition, you lose the premium paid for the option, along with any commissions and fees related to its purchase.
Things to Consider When Exercising an Option
What kind of option do you have? This is crucial because contracts have different guidelines. American-style contracts allow you to exercise them before their expiration date. European options may be exercised only after the contract has expired.
Can you exercise your options? In some cases, such as with employee stock ownership plans (ESOPs), your shares may be vested, meaning you need to wait a set amount of time before exercising the option.
Will the cost outweigh the benefits? Exercising a contract costs you commission money, so ensure the exercise price will make you money; otherwise, you'll pay more in fees and lose out on potential profit.
Are there taxes involved? Consider any tax implications associated with the type of contract you are exercising. For example, an employee cashing out an ESOP will have to pay additional tax.
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