Exercising An Option. Is It a Good Idea?

NOTE:  Several corrections were made to the earlier version.

One of the basic properties of an option is that it represents the right to buy (call option) or sell (put option) at the strike price at any time before the option expires.

There is no obligation to exercise, and the owner of an option has other choices:  the option may be sold, exercised, or allowed to expire worthless.

Despite what I thought was an easy-to-understand principle concerning the stock option, visitors to this blog have asked basic questions in recent days – demonstrating that they do not clearly understand the exercise process.

For those who posted questions, and others who may also be uncertain about how to make a decision when the possibility of exercising an option presents itself, I've decided to dedicate today's entry to the topic of 'exercising an option – is it a good idea?

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Terminology

The owner of an option has certain rights and may exercise those rights any time before the option expires.

The seller of an option has certain obligations and may be assigned an exercise notice at any time before the option expires.  Notification that the option has been assigned to you occurs before the market opens on the next business day, following the exercise of the option.  Once assigned, the terms of the option contract must be fulfilled. 

Guidelines

1) If you sold an option and don't know when to expect to be notified that an exercise notice has been assigned to you, the simple answer is not to expect to receive that notice prior to expiration.  There are occasional exceptions, but it's not common.

2) If you sold an option and want to tell the option owner to exercise because you want to be assigned, forget it.  The option seller has no rights and must wait.  Only the option owner has the right to decide if and when to exercise.

3) When an option is exercised, the option itself is canceled, and may not be used again.  Instead of owning a call option, the call exerciser now owns 100 shares of the underlying stock (or ETF), for which he/she paid the 'strike price' per share. 

The put exerciser is now short 100 shares of the underlying asset, for which he/she received the strike price per share.

4) When assigned, the investor who was short that option, is no longer short the option (because it was canceled).  Instead, the assignee is now long 100 shares (If assigned on a put option) or short 100 shares (if assigned on a call* option).  The stock transaction occurred at the strike price.            *corrected

5) If you sell an option and want to be certain you are not assigned an exercise notice, the only way to do that is to repurchase the option.

6) Let's now look at this process from the point of view of an option owner.  Let's say you buy a Dec 35 call option when the stock is 32.  You pay $200 for the call. 

Three weeks prior to expiration, the stock rallies to $35.  The call is now trading at $3.50.  What should you do?

Some investors believe it is right to exercise the call option.   That is a huge mistake.  Why?

a) By exercising you are paying $35 for stock.  If you wanted to own stock, why did you by an option instead of stock?  There are good reasons for owning an option (see below), so it is foolhardy to exercise.

b) The option is worth $350.  If you sell the option, you collect that cash and (in this example) earn a profit.  If you exercise the option, it is canceled and the $350 in time premium is lost.  All you own now is 100 shares of stock for which you paid $35.  You never want to cancel an option that has time premium remaining.

c) What is time premium?  The price of an option has two components: the time value plus the intrinsic value.  The intrinsic value is the amount by which an option is in the money.  Or, it's the amount by which the stock price exceeds the strike price of a call (or is below he strike price of a put).
For example, if the stock is $38.15, then the intrinsic value of your Dec 35 call is $3.15 per share, or $315.

Subtract that $315 from the option price (premium).  With the stock trading at $38.15, the option premium depends on many factors, but let's assume it's $4.50.  To determine the 'time premium' in the option, subtract $315 from $450.  In this example, it's $135.  Whenever you exercise an option, you lose the entire time premium (but you keep the intrinsic value).  Why?  Because the option is canceled and turns into stock.  That stock is worth $3,815 and you paid $3,500 (plus an additional $200 for the option).  That's a net profit to you of $115. 

If you sell the stock, you collect $3,815.  But, if you had sold the option instead, you would have collected (in this example) $450.

Your choice:  Earn a profit of $115 by exercising (and paying an extra exercise fee and another commission to sell stock), or earn a profit of $250 and pay only one commission to sell the call option.  Easy choice.  Do not exercise.  Sell (or continue to hold) the call.

This is important.  if you are an option rookie, be certain this principle is clear to you.  If uncertain what to do, it's almost always better to sell the option than exercise.  There are exceptions, but this is not an appropriate time to discuss those exceptions.

There are other reasons not to exercise an option earlier than necessary.

to be continued

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