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?"
Do we exercise right away?
The 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 exercise.
While available, early exercising in practice is rarely a good idea.
Instead of exercising early, we should just sell-to-close our options contract if we want to cash out.
There are a few exceptions to the rule of never early exercising.
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 or sell-to-close.
Waiting to exercise until maturity is the most common course of action. At maturity, there is no extrinsic value left on the option, and we aren't forfeiting any value by exercising. The easiest way to exercise at maturity is by doing nothing. Brokerages will automatically exercise all in-the-money contracts at maturity. Brokerages will not automatically exercise at-the-money or out-of-the-money options at maturity.
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.
What if we don't have the underlying shares to sell for our in-the-money put option?
We are required to buy 100 shares per put contract we want to exercise. For stocks with low share prices like $F (trades around $13 per share), buying 100 shares is affordable for many people. However, $AMZN (currently trading around $3,400 per share) is unaffordable for many people. In the case we do not own shares of the underlying nor have 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.
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 should avoid this by manually selling our options contracts before the end of the day if we don't plan on exercising.
Being new to options, 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. For those of us with margin accounts, we should be extra vigilant to understand when we need to sell or exercise. If you know someone trading options, invite them to Archimedes today to learn together.