Types of exercise for option contracts

Types of exercise for option contracts

Akshit Gupta

This article written by Akshit GUPTA (ESSEC Business School, Master in Management, 2019-2022) presents the different types of exercise for option contracts.

Introduction

Exercising a call option contract means the purchase of the underlying asset by the call buyer at the price set in the option contract (strike price). Similarly, exercising a put option contract means the sale of the underlying asset by the put buyer at the price set in the option contract.

The different option contracts can be settled in cash or with a physical delivery of the underlying asset. Normally, the equity, fixed interest security and commodity option contracts are settled using physical delivery and index options are settled in cash.

Majority of options are not exercised before the maturity date because it is not optimal for the option holder to do so. Note that for options with physical delivery, it may be better to close the position before the expiration date). If an option expires unexercised, the option holder loses any of the rights granted in the contract (indeed, in-the-money options are automatically exercised at maturity). Exercising options is a sophisticated and at times a complicated process and option holder need to take several factors into consideration while making the decision about exercise such as opinion about future market behavior of underlying asset in option, tax implications of exercise, net profit that will be acquired after deducting exercise commissions, option type, vested shares, etc.

Different types of exercise for option contracts

The option style does not deal with the geographical location of where they are traded! The contracts differ in terms of their expiration time when they can be exercised. The option contracts can be categorized as per different styles they come in. Some of the most common styles of option contracts are:

American options

American-style options give the option buyer the right to exercise his/her option anytime prior or up to the expiration date of the contract. These options provide greater flexibility to the option buyer but also come at a higher price as compared to the European-style options.

European options

European-style options can only be exercised on the expiration or maturity date of the contract. Thus, they offer less flexibility to the option buyer. However, the European options are cheaper as compared to the American options.

Bermuda options

Bermuda options are a mix of both American and European style options. These options can only be exercised on specific predetermined dates or periods up to the expiration date. They are considered to be exotic option contracts and provide limited flexibility to the option buyer.

Early Exercise

Early exercise is a strategy of exercising options before the expiration date and is possible with American options only. The question is: when the holder of an American option should exercise his/her option? Before the expiration date or at the expiration date? Quantitative models say that it could be optimal to exercise American options before the date of a dividend payout (options are not protected against the payement of dividends by firms) and sometimes for deep in-the-money put options.

There are many strategies that investors follow while exercising option contracts in order to maximize their gains and hedge risks. A few of them are discussed below:

Exercise-and-Hold

Investors can purchase their option shares with cash and hold onto them. This allows them to benefit from ownership in company stock, providing potential gains from any increase in stock value and dividend payments if any. Investors are also liable to pay brokerage commissions fees and taxes.

Exercise-and-Sell

This is a cashless strategy wherein investors purchase the option shares and then immediately sell them. Brokerages generally allow this kind of transaction without use of cash, with the money from the stock sale covering the purchase price, as well as the commissions and taxes associated with the transaction. This choice provides investors with available cash in pocket to invest elsewhere too.

Exercise-and-Sell-to-Cover

In this strategy too, investors exercise the option and then immediately sell enough shares to cover the purchase price, commissions fees and taxes. The remaining shares remain with the investor.

Useful Resources

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 10 – Mechanics of options markets, 235-240.

Fidelity – Exercising Stock Options

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About the author

Article written in August 2021 by Akshit GUPTA (ESSEC Business School, Master in Management, 2019-2022).

This entry was posted in Contributors, Financial techniques and tagged , , , . Bookmark the permalink.

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