To exercise an option means to put into effect the right specified in the options contract.
An options contract gives the buyer the right, but not the obligation, to buy or sell an underlying security at a specified price on or before an expiration date. If the option buyer decides to buy or sell the underlying security, rather than letting the option contract expire, then he is exercising the option.
The buyer of a call option may exercise his right to buy the underlying security at the specified price. The buyer of a put option may exercise his right to sell the underlying security at the specified price.
If the buyer of an option does exercise his right, then the option seller, who is known as the option writer, is obligated to fulfill the terms of the option contract. If it is a call option, the option writer is obligated to sell the underlying security at the strike price to the option buyer. If it is a put option, the option writer is obligated to buy the underlying security at the strike price from the option buyer.
Just to reiterate this point, the option writer is not obligated to fulfill the terms of the option contract unless the contract is exercised by the option buyer. The buyer has the right to exercise his option but does not obligated to do so.
Let’s look at a couple examples of when it is the best time to exercise an option.
1. Assume an investor owns one call option for IBM, which is trading at $140 a share. The strike price of the call option is $142. It is in the option owner’s best interest to exercise the option when the price of IBM stock rises to, or above, $142 a share. Let’s say that the market value of IBM stock rises to $144 a share. The call option at this point should be exercised. In doing this, the option owner can buy the stock at the price of $140 a share, then immediately sell it at $142 a share. This generates a profit of $2 per share for the option owner (not counting the premium paid for the option).
2. Assume an investor owns one put option for IBM. IBM stock is trading at $140 a share and the strike price of the put option is $138. It is in the option owner’s best interest to exercise the option when the price of IBM stock falls to, or below, $138 a share. Let’s say that the market value of IBM stock falls to $136 a share. The put option at this point should be exercised. In doing this, the option owner can buy the stock at the market price of $136 a share, then immediately sell it at $138 a share. This generates a profit of $2 per share for the option owner (not counting the premium paid for the option).
After having read this article, investors now know what it means to exercise an option. Investors also should have gained an idea of the best time to exercise their options to earn maximum profit.
