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Introduction to exercising

Lesson in Course: Derivatives and options (expert, 6min )

I understand what it means to buy an option. When should I think about using my contractual right to buy or sell shares.

Options contracts, perhaps intentionally named so, provide us with additional options after we make the initial decision to purchase them. Once we own the contract between us and another investor, we need to decide if we plan to exercise our contractual rights or require the investor on the other side of the table to fulfill the agreement

Exercising a call option contract means we are deciding to buy the underlying stock at the strike price and exercising our put option contract means we are deciding to sell the underlying stock at the strike price. But how do we make that decision?

KEY TAKEAWAYS:

The two takeaways for this lesson are:

  • Understand why options below the break-even should not be exercised
  • Learn how to calculate the break-even

Being able to be confident in our decision to exercise will allow us to utilize options fully.

Economics of options

The first step in our decision-making framework is to determine if we have in-the-money options.

IN-THE-MONEY (Hit The Goal)

Options are in in-the-money when there is an intrinsic value to the option contract.

Options with intrinsic value are the only type of option that makes sense to exercise. In the case of an in-the-money call, we can make money by buying shares at discount, or in the context of an in-the-money put, we can make money by selling for higher than what the market offers. In either case, using the contract will benefit us. At-the-money and out-of-the-money options result in no gains for us and they should be never exercised.

However, while all in-the-money options have intrinsic value, not all of them should be exercised. For example, exercising an in-the-money put option also requires us to own at least 100 shares of actual shares, and we shouldn't try to do so if we don't have any shares. Additionally, sometimes exercising in-the-money options can still cause us to lose money. We'll dive into the reasons why below.

 

Our own economics

The second step to our decision is to determine if we would actually earn a profit. Does the difference between the strike price and the current price of the stock make more money for us than what we had to pay for the contract?

Profit and loss

The profit and loss of an option is how much we walk away with at the end of the day after factoring in the premiums paid.

Not all in-the-money options result in a profit for us.

Robinhood $FB call

In the example above of a $FB call option chain on Robinhood, we can see that the price of a $162.5 strike call option was $7.58 for the day. $FB stock at the time was trading at $164.64. While the option is technically in-the-money (the stock price is higher than the strike, $164.64 > $162.5) and we can buy at a discount to the market, exercising that option will result in a loss for us. We had to pay a price of $7.58 per share to the seller of the option just to gain $2.14 ($164.64 - $162.5) per share. To profit, we need the current share price to be above $170.08 ($7.58+$162.5).

 

Break-even

The break-even is the value that the underlying stock needs to be for our call options contract to be profitable.

Break-evens for call options are calculated by adding the option price with the strike price (strike + premium). In the example above, our break-even for the $162.5 $FB call option is $170.08. 

Break-evens for put options are calculated differently than calls. Since we are betting against the stock, we need the stock to be below the strike by more than the premium paid to be profitable. A put break-even is calculated as strike price minus the premium (strike - premium). In the example above our break-even for the $31.5 $AMD put is $30.67 ($31.50 - $0.83). 

While most brokerages calculate this for us, it's still an important concept to understand for advanced strategies covered in future lessons which combine several different options contracts.

 

 The choice to exercise our options offers some flexibility. We can choose to exercise just one of our contracts, some of our contracts, all of our contracts, or none of our contracts. By stepping through the decision framework broken down in this lesson, we can start forming a plan. Once we've decided, the next part of our plan is to determine when to exercise.

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