Exercise

Exercise is the action of implementing the right—but not the obligation—to buy or sell an underlying asset as specified in an options contract or a warrant. Think of an option as a special, time-sensitive voucher you bought. A call option is a voucher to buy a stock at a set price, while a put option is a voucher to sell a stock at a set price. When you decide to use that voucher, you are “exercising” your right. For example, if you hold a call option for 100 shares of Company ABC with a strike price of $50, exercising it means you are officially buying those 100 shares for $50 each, regardless of the current, higher market price. This action converts the potential value of your option into a real transaction, fundamentally changing your investment position from holding a right to holding (or selling) the actual asset.

Deciding when to exercise is the million-dollar question, and the answer isn't always as simple as it seems. The key is understanding when an option is profitable to exercise, or “in the money”.

You would only consider exercising a call option when the stock's market price is above the strike price.

• Example: You own a call option to buy shares of “Growth Co.” at a strike price of $100. The stock is now soaring at $130 per share. By exercising, you can buy the shares for $100 and they would be instantly worth $130. This $30 difference is your gross profit per share.

However, think before you act! More often than not, it’s more profitable to sell the option contract itself rather than exercise it. Why? Because the option's price includes not just its intrinsic profit ($30 in our example) but also its time value—the value of the time remaining until the option expires. When you exercise an option before its expiration date, you forfeit that remaining time value. An investor will typically receive more cash by selling the appreciated option to another trader.

You would only consider exercising a put option when the stock's market price is below the strike price. This is often used as a form of insurance for your portfolio.

• Example: You own shares of “Steady Inc.” and bought a put option with a strike price of $50 to protect your investment. The market takes a dip, and the stock falls to $35. By exercising your put, you can force someone to buy your shares at the protected price of $50, saving you from a $15 per share loss.

Just like with calls, the dilemma of exercising versus selling exists. If there's still significant time left before expiration, your put option contract will have time value, and you could likely sell it for more than the intrinsic profit you'd get from exercising.

The ability to exercise an option depends on its style, which has nothing to do with geography and everything to do with rules.

• American-style options: These can be exercised at any time up to and including the expiration date. This offers maximum flexibility. Most options on individual stocks traded in the U.S. are American-style.
• European-style options: These can only be exercised on the expiration date itself. They are less flexible but can be simpler to price. Many index options, like those for the S&P 500, are European-style.

You don't have to show up on a trading floor with a briefcase of cash. The process is handled electronically through your broker.

1. Step 1: You submit an “exercise notice” to your broker, indicating your intent to exercise a specific options contract.
2. Step 2: Your broker submits the request to the Options Clearing Corporation (OCC), which acts as the central clearinghouse for all U.S. options trading.
3. Step 3: The OCC randomly assigns the exercise notice to a broker whose client wrote (or sold) that same option.
4. Step 4: The transaction is settled. If you exercised a call, the shares are purchased and appear in your account; if you exercised a put, the shares are sold from your account. The corresponding cash is debited or credited.

For a value investor, options aren't for wild speculation; they are strategic tools. The decision to exercise is therefore a tactical one, not an emotional one. A prudent investor might exercise an option in specific situations:

• To Acquire Stock: If you bought a call option on an undervalued company you genuinely want to own for the long term, and its price is still attractive relative to its intrinsic value, you might exercise it to start your position at a locked-in price.
• To Capture a Dividend: An exception to the “don't exercise early” rule can be to exercise a call option just before an ex-dividend date. If the upcoming dividend payment is greater than the remaining time value of the option, it can make financial sense to exercise to capture that payout.
• To Hedge a Position: A value investor holding a wonderful business for the long haul might buy puts as insurance. If a feared downturn occurs, they might exercise the puts to sell their shares and protect capital, intending to buy back in later at a lower price.

Ultimately, a value investor's best friend is patience. Understanding that an option's market price often holds more value than its exercise value is key. Unless there's a compelling strategic reason, the default move for taking profits on an option is almost always to sell the contract, not to exercise it.