Bullish Outlook

Let’s do some exercise: Exercising your options

Montréal Exchange
October 13, 2020
5 minutes read
Let’s do some exercise: Exercising your options

In this article, we’ll talk about exercising call options and why investors would want to do so. Read the article to find out the pros and cons of exercising a call option.

You discover a pharmaceutical company that trades at $100 a share and has a COVID-19 vaccine in phase 3 clinical testing. It’s extremely promising, but the stock price is too expensive for your account’s buying power ($10,000).

Instead of buying 100 shares and putting all your eggs in one basket, you decide to use a call option.

“Call options give you the right to buy the underlying stock at the strike price until expiration. To gain this right, you simply pay the option price (premium) to acquire this call option in your options trading account.”

For illustrative purposes, let’s say you pay a $2.00 premium for a 3-month ATM call option that gives you the right to buy the stock at $100 within this 3-month period. Buying the call option costs you $200 ($2 x 100) *Not taking trading commissions into consideration

You’ve just gained exposure to 100 shares of this pharmaceutical company for only $200 (vs. $10,000).

A month goes by and you wake up in the morning to see “Breaking News Alert: Vaccine gets approved for sale” on your phone. As soon as that news hits the press, the stock price soars to $170 at the open!

Your heart is racing, and your adrenaline is pumping. You are now faced with three choices:

  1. Exercise the call option (convert the call into shares)
  2. Close your position (take your profit and go)
  3. Wait and see (since the option still has two more months before it expires)

Option 1: To exercise any option, you need to call your broker and instruct them to exercise it. Since you have a $100 call option, you’d better have enough cash in your account to exercise it. The math behind exercising a call is easy: Simply take the call’s strike price x 100 (i.e., the multiplier) x the number of option contracts. In our case, we will need $10,000 ($100 x 100 x 1). If you don’t have enough money to exercise the option, don’t worry, you can simply close your position by selling the call instead.

Option 2: Selling the call option to close your position makes a lot of economical sense for many reasons:

  1. If you decide to exercise an option before expiration, you are essentially forfeiting any time value that is remaining in the option premium. Therefore, by selling the option, you will get to recuperate the time value.
  2. The reason you bought the call option is because you didn’t want to put up 100% equity in the stock position. Why would that change now?
  3. Depending on your broker, trading commissions could be more expensive when you exercise an option (vs. closing it). You should know the cost involved before exercising.

Let’s go back to our $100 call example. The stock is trading at $170, so you can sell this call for $70 (or $7,000) and make $68 net (or $6,800) from your $200 initial investment. If this return isn’t good enough for you, you can always go with option 3 (wait and see) since there are still two more months before the call option expires. Who knows? The stock price might keep going up.

Exercising an option makes sense when you want to convert your call option into actual shares or collect dividend payments from the company. But at the end of the day, if all you want is to make a profit and move onto another trade, closing your option position will help you achieve just that.

The strategies described in this blog are for information and training purposes only. They should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

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