Exercising An Option. Is It a Good Idea? Part II

(Part I)

There are two more good reasons for not exercising an option earlier than necessary [NOTE:  This information is for investors who own options because only the owner has the right to exercise.  The seller has no rights and has nothing to say concerning the exercise of an option.]

1) Cost.  This is a minor but not insignificant reason.  When you exercise an option and convert it into a long (call option) or short (put option) stock position, many brokers charge a fee for exercising the option.  If your plan is to get rid of that stock position, there is no reason to pay that exercise fee.  Simply sell your option instead.

If your plan is to exercise a call, then you acquire stock (by paying the strike price), and it costs real cash – the interest paid to own the shares.  What's your hurry?  Why pay interest?  Exercise at the last possible moment – and that's when expiration arrives.  And it's an automated process.  There's nothing for you to do because exercise is automatic when the option is in the money at expiration.

Unless you have a good reason, it's usually better to sell the option, rather than exercise.

2) Risk. It's time to discuss the primary reason why early exercise of an option is a serious mistake.

When you own an option, you have limited risk.  The most you can lose is the cash you paid to buy the option.  But, once you exercise that option, your risk increases significantly.  It's true that if the option is deep in the money, then that risk is minimal.  But for some reason, too many novice investors believe it's a good idea to exercise an option as soon as it moves into the money.  I hope the discussion in Part I convinced you that this is a very bad idea.

Assuming you understand how to avoid that trap, let's look at a situation in which you own the ZZX Jul 80 call, for which you paid $2, and decide to exercise the option one week prior to expiration when the stock is trading at 84.


Example, Thursday morning of expiration week

Original position: Long one ZZX Jul 80 call, current value: $450

Post-exercise: Long 100 shares of ZZX, current value: $8400.

ZZX is suddenly in the news. The company pre-announces that earnings are going to be lower than anticipated.  On that news, the stock opens for trading at $70 per share.

If you still owned the call option, it would become worthless and your original $200 investment would be lost. 

If you now own stock (for which you paid $80 per share to exercise, plus $2 per share you paid for the call option), you loss is $12 per share, or $1,200.

By exercising, you placed yourself in jeopardy – and in this example, something bad happened.  Sure it was unexpected, but you had nothing to gain by exercising and the market punished you (by $1,000 per option) for making that mistake. 

Let's hope this example remains hypothetical and you understand why early exercise is not a good idea.

Early assignment

Many investors fear being assigned an exercise notice.  It's nothing to fear.  In fact, it can sometimes be a gift.  Suppose you had written a July 80 covered call on ZZX and were assigned when the stock was 84. 

Congratulations.  You sold your stock at 80 and the investor who exercised early saved you from a 10-point loss.  Early assignment does not occur often, and most of the time it doesn't make any difference.  But occasionally, it's a gift.  So please don't fear it – look forward to the possibility.

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