Options are often bought and held until right before they expire. If you’re a new investor, this process may seem like something you want to avoid, as it comes across as risky. After all, why would you want expired options?
Options are rarely exercised because many investors choose to close them instead — you need to complete this process before they expire. Options give you the right to exercise, but you’re never obligated to go through with it. You can close contracts to earn a profit, which more people tend to do.
However, how do you know it’s time to exercise the option or close the contract? Many new investors struggle with this concept. That’s why we made sure to break down everything you need to know right here!
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Table of Contents
What Is the Right To Exercise?
New investors need to understand that options give you the right to exercise; they don’t require you to sell or buy. For example, a call contract gives you the right to buy 100 shares of the underlying stock, and a put gives you the freedom to sell the underlying shares.
BUT, no one forces you to make a move.
According to Investopedia, exercising refers to using your right to buy or sell the underlying security specified in the contract. Knowing the right time to exercise an option contract can become a challenge. You’ll need to consider many different factors, including how much time is left until the option expires.
In many cases, options are closed instead. There’s no reason to exercise options that have higher values as more time passes. If you were to exercise your right on those options, you would be losing the profit — hence why most investors never exercise their options.
Also, keep in mind that there’s a difference in exercising calls and puts. With calls, you receive the right to buy. In contrast, puts give you the right to sell. When you exercise a put, you’re also obligated to pay fees and buy the stock from the holder.
Why Aren’t Options Exercised?
The biggest reason options investors don’t exercise options is that there’s no obligation to do so. Most of the time, closing the option by selling it through an offsetting transaction will be the better choice for you. That way, you can still earn a profit while getting rid of the option you don’t want anymore.
Why You Shouldn’t Exercise Options?
There are some fundamental reasons why you should hold off on exercising any options you have. However, most of it boils down to not making money or spending more than you invested. Make sure to consider the following before you start making any trades:
Time Raises the Value
The time left until the expiration date can have an impact on the value of the option. Plus, the strike price and the share price need to be within a specific range of each other to maximize your profit.
Time adds value to the stock in the option contract. For example, say you have options that expire one week from now and another with the same underlying stock that expires in three months. In that case, the time makes the one with three months left more valuable, also known as the concept of time value in investing.
In other words, you can expect a higher value on options contracts with a later expiration date because there’s the chance it increases in value before the expiration date.
You can determine time value with this simple formula: option premium minus the intrinsic value. The premium for the option then adds the time value and the inherent value together. So, it wouldn’t be profitable to exercise an option with a high time value since you would lose that benefit.
This video can help you understand why you do not want to exercise your options early:
Exercising Is Risky
Exercising an option can be riskier. When you have a call option, the most you can lose is the value of the option. But, when you exercise the option, your account is vulnerable to losses due to the volatility in the price of the purchased shares.
In options trading, you don’t need to directly own the shares to make a profit from a price increase, so exercising can simply be an additional step. Overall, it makes sense to hold onto your options for as long as possible. Doing so is going to be much safer for your money.
Less Transaction Cost
Selling options cost you a commission. When you exercise the option, you have to pay a fee, then a commission on top of that to sell. These two hits at once can make it not worth exercising your right to sell at all.
If you know that you’ll make nothing from the trade, why pay to do it? These additional charges usually make it not worth selling. However, each broker is different, so it’s worth doing the math for yourself.
Margin Loans
Finally, if you don’t have the entire sum to cover the cost of exercising the option, you’ll also be exposed to margin loans when you convert a call contract into shares. While you now own the stock, you won’t be earning interest on your cash. Instead, you might be obligated to pay your broker a fee or interest on the margin loan.
These loans are set up by brokers and allow you to borrow funds to purchase securities. Options are contracts and not the underlying stocks, meaning you aren’t paying the total price when you buy options. But, you are required to pay the full price for buying shares at the option’s strike price after exercising!
Again, if this situation applies to you, these margin loans can eat up a portion or cause you to lose all of the profits you expect to make from exercising.
Rare Cases Where Exercising Options Is Justified
There are a few cases where you may want to exercise your right on an option. If stock happens to pay a large amount of money in dividends, then exercising may be worth the time. You would have access to those dividends over the long term, which might pay all the commissions.
Plus, there might be cases where the option is well into money and your analysis tells you that the best time to act on that trade is now. In such situations, it’s usually worth taking some of the hit on your profits and exercising the stock. If you wait for the option to expire, you might lose a bigger chunk of your potential profit.
However, the main reason to exercise is when you want to own the underlying stock — that’s usually it! Since there are so few cases where you should exercise, it makes sense that investors rarely take that route with their options.
If you want to learn more, you may want to read through The Options Course Workbook by George A. Fontanills, which contains plenty of information and exercises you can work through to understand options trading better. You should always make sure you understand investing and trading well before you move onto the market.
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Conclusion
There are several reasons why you don’t want to exercise the option before it expires. In most cases, exercising the option contract won’t get you anywhere, and you end up paying excessive fees. Instead, close the contract through an offsetting sale. Waiting too long will cause it to exercise automatically, so always keep track of how much time you have!
Overall, when you decide to close the option matters. Many people don’t want to exercise it since they will more than likely lose money in doing it. Options can be rather complicated, but with proper training and knowledge, they can be very profitable. So be sure to continue investing in your trading education.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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