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When to exercise options

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

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

Eureka!

What it's about: A decision-making framework to decide when to exercise.

Why it's important: Exercising at the right or wrong time can capture or destroy value.

Key takeaway: Selling-to-close is a less cash-intensive and preferred alternative to exercising.

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.

It is possible to exercise an option before maturity
What is Early exercise?

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

While available, early exercising in practice is rarely a good idea. 

The case against early exercise

Exercising our options converts a time-based contract into a price-based outcome and eliminates all remaining time value. We end up leaving money on the table when we early exercise.

Instead of exercising early, we should just sell-to-close our options contract if we want to cash out.

The alternative to early exercise

Selling our profitable in-the-money contract allows us to retain the extra value left on our options contracts. In the example above, by choosing to sell 17 days before maturity, we are paid an extra $1 compared to early exercising. In almost all cases, this is the preferred way to take gains or cut losses. Closing out our option position provides the additional benefit of not needing to have the extra money required for exercising—it's a win-win.

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

The case for early exercise

Expert investors may choose to early exercise a call option to be able to receive dividends. Owning a call option does not give us the same rights as owning the underlying. To receive dividends, we need to own the underlying shares and we can do so by exercising our call option. We would choose to early exercise a call option if the value of the upcoming dividends exceeds 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 are a handful of very specific tax situations where it's advantageous for us to sell shares at a specific price before the new tax year. Depending on our tax bracket, the tax savings by exercising our put options 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 or sell-to-close.

Exercise or sell-to-cover at maturity?

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.

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 looking into buying massive multi-million dollar positions will buy options instead of stock. Buying a large number of shares in a short amount of time drives prices up—splitting the order between options and shares helps keep purchase prices at a minimum.

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.

Margin calls can result in forced selling if pice drops

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.

Actionable ideas

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.

Glossary

What is Early exercise ?

Early exercising as an options trader means that we are exercising our in-the-money positions before maturity.