Summary: The owner of an option contract has the right to exercise it, and thus require that the financial transaction specified by the contract is to be carried out immediately between the two parties, whereupon the option contract is terminated. When exercising a call option, the owner of the option purchases the underlying shares (or commodities, fixed interest securities, etc. Exercising a put option involves the sale of the underlying shares.
It’s common to hear investors speak of exercising a stock option, or sometimes a stock warrant, and what that means is that they are planning to use the terms specified in the option to purchase the stock either to hold or to resell. Having a stock option gives the holder a set price for the stock, so long as they use it by the designated deadline, regardless of the market value.
What is Exercising a Stock Option
A stock option sets the price of a stock at a specified value, often called a strike price, that the call option holder is guaranteed to be able to purchase the stock for. For example, if a stock option is given and has 10 years until it expires with the strike price of the option being $20 per share, then so long as the option is exercised within 10 years, each share covered will only cost the option holder $20. The value of having an option comes into play when a stock value climbs above the strike price. Say the stock mentioned above is now valued at $50 at the end of the option deadline. If the option holder exercises the option, they pay only $20 a share for stocks worth $50 each. An option holder can exercise the option, pay the strike price for each share, and then resell the stock for an immediate profit when circumstances like that exist.
The mechanics of exercising a put option are similar but the option holder sells the stock (either from his inventory or selling it short). As can be deduced, a put option is a bet on the underlying stock price declining in the future, therefore the put option holder locks in a higher future stock price when the put option was purchased. Exercising the put option allows the investor to sell the stock at a higher price than the current market price (if the put option is in the money) and pocket the difference.
How to Exercise a Stock Option
There are several steps that should be followed to ensure the option is exercised correctly.
- Make sure the option has been vested. Many options have time requirements that must pass before the full amount of shares can be purchased. It’s generally best to wait until the maximum amount of shares can be purchased by the option before using it.
- Choose what method is wanted for the transaction: cash, cashless or stock swap.
- Determine how many shares should be purchased or traded via the option.
- Estimate the net proceeds that will be provided according to how the market price is established, as outlined in the option.
- Complete a stock option exercise form or letter depending on what the option grantor requires.
- Return the completed form to the stock administrator, broker or company that the option specifies.
- Maintain records for taxation purposes, as proceeds will carry a tax liability. Keep copies of the exercise statements and of the 1099-B provided by the broker.
When the option can be exercised for a profit, it is said to be in the money. When the option exercise would result in a loss, the option is said to be out of the money.