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Introduction to exercising

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

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

Eureka!

What it's about: Exercising our options contract to buy or sell a stock should be considered in certain situations.

Why it's important: We shouldn't exercise options that cause us to lose money.

Key takeaway: The underlying stock price has to be above the break-even price to consider exercising a call option. The stock price has to be below the break-even price to consider exercising a put option.

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.

What is Exercise?

Exercising means the holder of an options contract is electing to put into effect the right to buy or sell the underlying at the strike price specified in the options contract.

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.

Find our options that have intrinsic value

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

The price paid for the option needs to be considered

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

FB call option on Robinhood
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 the break-even price of $170.08 ($7.58+$162.5).

 
What is 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 + option price). In the previous example above, our break-even for the $162.5 $FB call option is $170.08. 

AMD put option on Robinhood

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 price paid to be profitable. A put break-even is calculated as strike price minus the price of the option (strike - option price). In the example above, our break-even for the $31.5 $AMD put is $30.67 ($31.50 - $0.83). 

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.

 

Actionable ideas

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.

Glossary

What is 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 + option price). A put break-even is calculated as strike price minus the price of the option (strike - option price).

 

What is Exercise ?

Exercising means the holder of an options contract is electing to put into effect the right to buy or sell the underlying at the strike price specified in the options contract.