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When to exercise options

Lesson in Course: Derivatives and options (expert, 5min )

I understand that only profitable contracts should be exercised. When should I prepare to do so?

Let's assume our option is in-the-money and we are above the break-even point, and we have some time left before the maturity date. With a triple-winning combination, we could easily find ourselves asking the question, "Do we exercise now?" 

KEY TAKEAWAYS:

The three takeaways for this lesson are:

  • Understand why investors rarely exercise before the maturity
  • Know what happens if we don't have the money to exercise 
  • Avoid the pitfalls of margin

Being confident in knowing when to exercise can mean the difference between a nice payday or unexpected losses.

Do we exercise right away?

Options we trade are American options, which allow us to exercise them at any time. Deciding to do so before the maturity date can lead to early exercising.

EARLY EXERCISE

Early exercise means to exercise the option agreement before the maturity date to buy or sell the underlying at the strike price.

While it's absolutely possible to early exercise, in practice, it's rarely a good idea. When we exercise, we are walking away from any extrinsic value left on the time. 

Exercising literally lops off the value left on our options because we are converting a time-based contract into a price-based outcome of buying or selling shares.

Cashing out early

Instead of early exercise, we should just sell our options contract to take our gains early.

Selling our in-the-money and profitable contract allows us to retain the extra value left on our options contracts. In almost all cases, this is the preferred way to cash out. Selling the option provides the additional advantage of not needing the extra money that exercising requires—it's a win-win for us.

The rare exceptions

There are a few exceptions to the rule of never early exercising.

Expert investors may choose to early exercise a call option to be able to receive dividends. In these cases, the dividend paid on the underlying shares needs to exceed the remaining extrinsic value. We'll cover how to make these tricky calculations in future lessons and introduce calculators to help us make confident decisions faster.

 

For put options, there may be a very specific tax advantage to sell shares at year-end at a specific price before the maturity in the new tax year. Depending on our tax bracket, the tax savings by exercising our put option and securing the right to sell shares at a strike price may outweigh the future increase value in the options contracts.

Waiting to exercise

If we decide to hold on to our options, the next decision we need to make is if we exercise at maturity.

EXERCISE AT MATURITY

We have to make a decision to exercise or sell before the market closes on the maturity date.

Exercising at maturity is the most common time options contracts are exercised. At maturity, there is no extrinsic value left on the option, and we aren't forfeiting any value by exercising. If we held on to our in-the-money options until now, our brokerage will automatically exercise the contracts and the other party gets assigned. For call options, we buy 100 lots of the underlying at the strike price and for put options, we sell 100 lots of the underlying.

What if we don't have the cash to exercise a call option? Most brokerages will sell our option one hour before the market closes on the day our options expire to avoid the awkward scenario. With only 1 hour of trading left, the extrinsic value is nearly $0 and we don't stand to lose anything on the trade.

Trading down to the last hour

We might be wondering who would buy 1-hour options at the end of the day? Certain banks and financial institutions are required to hedge their risk at all times, including that last hour. Additionally, hedge funds that are trying to buy into a position with massive multi-million dollar purchases will buy options so that they don't move the markets trying to put in a large order. If there aren't enough sellers of the underlying, large order will drive up the price of the shares making the purchase more expensive

What if we don't have the underlying shares to stock for the in-the-money put option? We would theoretically need to buy 100 shares per contract we exercise. For low share price companies like Ford, $F trades around $13 per share,  buying 100 shares temporarily is within reach for many people. However, $AMZN, currently roughly trading at $3,400 per share, is unaffordable to many. In the case we do not have the shares or the money to purchase the shares, brokerages will sell our in-the-money put options one hour before the market closes on the day our options expire, even if it's not profitable for us.

 

Watch out for margin

If we are approved for margin, the brokerage will elect to use margin to exercise instead of automatically selling our contracts.

Brokerages will use margin to lend us money to exercise if we are approved for margin. This can lead to a very nasty margin call depending on stock movement the next day. We really should avoid this by manually selling our options contracts before the end of the day if we don't plan on exercising.

As beginners, we should avoid exercising until we have a plan to use options to purchase long-term investments. Selling options will help us capture the gains we are looking for without unwillingly expanding our position size or risk due to exercising. For those of us with margin accounts, we should be extra vigilant. If you know someone trading options on margin, invite them to Archimedes today.

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