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.
Exercising a call option contract means that we are deciding to buy the underlying stock at the strike price. Exercising our put option contract means that we are deciding to sell the underlying stock at the strike price. But how do we make that decision?
Economics of options
The first step in our decision-making framework is to determine if we have in-the-money options.
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 never be exercised.
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 requires us to own at least 100 shares of the underlying stock, and we shouldn't try to do so if we don't have any shares. Additionally, exercising in-the-money options in certain circumstances can 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
Not all in-the-money options result in a profit for us.
Break-evens for call options are calculated by adding the option price with the strike price (strike + option price). In the previous example above, our break-even for the $162.5 $FB call option is $170.08.
While most brokerages calculate our break-evens for us, it's an important concept to understand for advanced strategies covered in future lessons which combine several different options contracts.
Certain brokerages or exchanges will automatically exercise our at-the-money options if the contracts are within a few cents shy of being in-the-money. In this case, we need to be vigilant and confirm with the exchange/broker if we want to exercise. 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.