You’ve probably heard that if you trade stock options correctly, they can be worth a lot of money, and that is undoubtedly true.
But do you know how stock options work? Or what a stock option is? Do you know what it means to exercise options? Do you see the distinction between exercising calls and puts?
How do Options Work?
This next section explains what exercise stock option means, and you need to learn and understand stock options and how they operate.
What is a Stock Option?
A stock option is a financial contract that can grant a buyer his right to purchase or sell a stock at a strike price (predetermined price) before its expiration date. A buyer does not need to buy the stock; he just has the right to do so, and he may choose not to exercise his option.
A buyer can buy many stocks through a brokerage firm. Although some companies choose to give their employees stock options, they can choose to use that opportunity to purchase the company’s shares. This time is known as the vesting period.
What Does it Mean to Exercise Options?
If you choose to exercise your options, that just means that you can buy or sell your option stocks as long as it is in the option agreement. If you decide to enforce your right in terms of the stock options, that would mean that you are exercising your options.
If you decide to exercise some of your stock options, it would be straightforward; all you would do is ask your brokerage firm to exercise them for you or to let them ‘expire in the money,’ and automatically, they would be exercised.
Difference Between Exercising Calls and Puts
You can buy and sell two distinct types of options: puts and calls.
Calls
A contract that is a call option gives the option holder the right but does not obligate them to purchase a specific number of shares from a particular stock at a specified price (strike price) before an expiration date.
Puts
A contract that is a call option gives the option holder the right but does not obligate them to sell a specific number of shares from a particular stock at a specified price (strike price) before an expiration date.
What Happens if you don’t Exercise Your Options?
Options are worth nothing once the expiration date hits, and then they trade much below their original strike price. The closer an option gets to its expiration date, the more it loses its value faster. On the third Friday of each month, the monthly options expire, while weekly options will expire every Friday. Options trading can be pretty unpredictable volatile on expiration day.
When Should you Exercise Your Options?
Many options expire out of the money or expire worthless, so it would not make much sense if you exercise those options. If your options are in the money, you may want to buy or sell those underlying, then exercising them would make more sense.
When the call option is “in the money.”
If you want, you can exercise the call option if the strike price is cheaper than the stock price.
An example would be if the strike price is $40 and the stock price is $30 exercising the option would not profit you financially because you could buy the stock option for 10 dollars less than the strike price option.
When you want to hedge a short sale
Exercising a call option is used to hedge a short stock position will continue to increase in value.
A short stock position includes selling shares borrowed from your brokerage firm, which you do in the hope of repurchasing the shares at a lower cost.
Instead, if the share price happens to rise, you may use a call option with the right strike price to prevent losses.
Exercising Call Options
If you own a call option when the stock price is larger than the strike price, it would make sense to exercise your call.
In so doing, you would be buying the stock at a smaller price, and then you would sell it to the market at a higher cost, or you could hold onto it for the long term.
Exercising Put Options
If a put option is owned and the stock price is comparably lower than the strike price, it would again make sense to exercise that option.
In so doing, you can then sell the stock at a much higher price and repurchase it at a lower price.
Bottom Line
Stock options have scared many people just because of how complicated they could become, but they are often used to speculate on market costs and portfolio hedging.
Calls and puts can improve, increase returns, and balance risks when understood and used correctly.
Traders should be using them simultaneously with the portfolio theory to minimize risks of owning stocks and overall volatility.
Remember to see and determine what actions give you the best results when trying to exercise stock options; just keep in mind the potential disadvantages.
