What Is an Option?
An option is a derivative or financial contract that gives the holder the right (but not the obligation) to purchase or sell an underlying asset at an agreed-upon price by a specified date in the future, which is known as the expiration date. Assets can be anything ranging from stocks, bonds, currencies, indexes, interest rates, and commodities. Contracts commonly represent 100 units or shares of the underlying asset.
These financial instruments are fairly versatile. But they do require that the buyer pay a premium for the rights set forth in the contract. It just depends on the type of option an investor holds. For instance, the holder of a call option has to right to buy the underlying asset at the agreed-upon price by the expiry date. A put option, on the other hand, gives the holder the right to sell the asset at the price by the expiry date.
Options are traded for a number of reasons. For instance, speculators use them to keep a leveraged position in the underlying security or asset at a cost that's lower than actually buying shares. The use of options has thus increased dramatically to help profit from or hedge against the volatile movements of stock prices.
Key Takeaways
- An option is a contract that gives the holder the right, but not the obligation, to buy or sell an asset at a set price by a certain date.
- Exercising an option means investors can purchase or sell the underlying asset at the agreed-upon price.
- Investors must declare their intentions to their brokerage firm that they wish to exercise the option.
- The Options Clearing Corporation is notified and assigns it to a clearinghouse, which gives it to a client who has written (but not covered) that option.
- American and European options can be exercised, sold, or allowed to expire worthless on the expiration date.
How Exercising Options Works
Exercising an option simply means purchasing or selling the underlying asset named at the price agreed upon in the contract. This strike price is used to execute the transaction regardless of the asset's market price at the time the option expires. Remember, option holders have the right to exercise their options, but are not obligated to do so.
There's typically a procedure to follow when an investor wants to exercise an options contract. An investor must inform their brokerage company that they wish to exercise their options contract. The firm sends a notice to the Options Clearing Corporation (OCC).
The organization chooses a random clearinghouse, to which it sends the notice. The firm is responsible to allocate the option to a client. The customer must have written that option but must not have covered it.
Expiration dates follow three cycles: January, February, and March. The January cycle is comprised of the first month of each quarter (January, April, July, and October) while the February cycle consists of the second month of each quarter (February, May, August, and November). The March cycle consists of the final month of each quarter (March, June, September, and December).
Exercising an Option on the Expiry Date
There are two types of options: American and European options contracts. American options can be exercised at any time up to and including the expiration date of the option. However, European options can only be exercised on the date of expiration.
Because expiration dates are usually identified just by a month, a specific date is identified within the expiration month that is used as an exact deadline. For both types of options, this deadline is the third Friday of the expiration month. An investor normally has until 4:30 p.m. CT on the third Friday of the month to instruct their broker to exercise an option.
Options can expire either in the money (ITM) or out of the money (OTM). Those that are in the money can be exercised while OTM options end up becoming worthless. A call option is in the money when the strike price is lower than the underlying asset's price. A put option is in the money when the underlying asset's price is lower than the strike price. The opposite is true for out-of-the-money options for calls and puts.
What Does Exercise on Expiration Mean?
Exercising an option on the expiration dates means that an investor fulfills their rights as per the contract. As such, the holder of a call option can buy the underlying asset while the holder of a put option can sell the underlying option when they exercise their contract at expiration.
What Happens on the Expiration Date of Options?
The strike price can be more or less than the price for the underlying security. When expiration hits, the investor has a few choices, including selling the option, exercising it, or letting the contract expire worthless. Keep in mind, though, that if the option is in the money (even by a penny), the broker automatically exercises it. That is, unless, the option holder instructs them not to do so.
Can Some Options Be Exercised Only on Their Expiration Date?
European options can only be exercised on the expiration date. American and Bermuda options, on the other hand, can be exercised at any time—either on or before the day they expire.
Can I Settle Options Before the Expiration Date?
You can only settle American options before the expiry date. These options can also be exercised at expiration. Bermuda options, which are a spin on American options, can also be exercised at any time. European options, though, can only be exercised when they expire.
