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What does it mean to 'exercise an option?'

What does it mean to 'exercise an option?'

An options contract does not affect the underlying securities until the option is exercised, meaning that the option or buy or sell the security is utilized. Many options trades do not directly touch the underlying securities – investors worldwide make plenty of money buying and selling the options contracts themselves.

Options have time-value inherent in them based on how the underlying securities are priced and when the options expire, and traders will speculate on when and if someone might actually “exercise the option,” and thereby use the rights of the contract holder to buy or sell the underlying securities. The contract names the strike price at which the holder of a call option can buy a security; or, for a put option, the price at which the holder can sell the security.

A call is “in the money” and likely to be exercised if the market price of the securities is higher than the strike price, because the owner of the call option has the right to call in a buy order, and get a deal at the lower price, and then turn around and sell it for a profit if he or she chooses to.

A put is “in the money” when the market price is lower than the strike price on the contract because now this person can go buy the shares cheaply in the market, and turn around and sell it at a premium to whoever sold him the option that bears the higher strike price.

In both cases of being in the money, the owner of the option is likely to exercise it. An “exercise notice” makes its way from the client’s broker to the option seller with the help of the Options Clearing Corporation, and the seller of the option is legally obligated to fulfill the order at the strike price.

Keywords: risk, call option, put option,