How to exercise Options

When exercising options, they differ in the time at which they can be exercised. European options can generally only be exercised at the end of their term. Usually, options are structured with terms of 1, 2, 3, 6, or 12 months, but they can also have terms of several years. American options, on the other hand, can be exercised at any time during the term.

The maturity date of an option with a term of three months or longer is generally the third Friday in the month of the end of the quarter. This day is also known as the coven because the expiration date of the futures contracts (options and futures) regularly causes more or less large market price fluctuations on the stock exchanges.

Exercising options – American vs. European options

With regard to the possible exercise of options, a distinction is made between American and European options. With American options, however, holders of a call or put option can exercise their right to buy or sell at any time during the term of the option.

This has many advantages and is also a reason why the majority of contracts traded at Eurex are American options.

Only index options traded at Eurex are generally structured in a European style and are settled in cash between buyer and seller.

American options offer a much wider choice of underlyings, maturities, and strike prices and have much higher liquidity than European options. As a result, the spreads, i.e. the gap between the bid and ask price, are also significantly smaller.

This is important because a stock option usually relates to 100 shares and therefore considerable costs can be saved if a large number of transactions are concluded. The higher liquidity ensures that prices are fixed much more frequently. This also means that orders can be executed much faster, for example when limit orders are placed.

The options traded on the Chicago Board Options Exchange (CBOE) in Chicago are very attractive, especially for professionals in this country, due to the postponed trading hours. On average, options on about 3,000 stocks, more than 20 indices, and 150 ETFs are traded on the CBOE, which is about ten times the volume traded on Eurex.

Typical name of an option:

AAPL, Call, March 20 20, 75 €

AAPL = share name (here Apple)
Call/Put = call or put option
20 March 20 = due on 20 March 2020
75 € = Exercise price / strike

When does it make sense to exercise or let options expire?

Buyers of a call option will only exercise their option if the price of an underlying asset has risen above the strike. They make a profit from the difference between the share price existing at the time of exercise and the agreed exercise price, less the option premium paid. If, on the other hand, the share price has fallen, they will of course not exercise the option and let it expire, as they can buy the share or another underlying asset on the market at a lower price.

Buyers of a put option will exercise the option if the price of the underlying asset has fallen below the strike. The gain is calculated as the difference between the strike price and the actual value of the underlying, less the option premium paid. Otherwise, they will not exercise the option because they can sell the stock on the market at a higher price.

The sellers, i.e. the “writers” of options, will in any case receive the option premium to be paid by the buyer. They also bear the risk from the share.

For sellers of a call, the loss depends on whether they already own the share. If the share price actually rises, they must deliver the share at the exercise price, i.e. at a lower price. In this case, they can still make a profit if they originally bought the share at a lower price than the exercise price. However, they must waive the difference to the actual market price.

If, on the other hand, a seller does not own the share, he must buy the share on the market and make a loss in the amount of the difference between the current price and the exercise price, less the option premium received. If, on the other hand, the share price falls or stagnates and the buyer does not exercise the call option, they make a profit in the amount of the option premium.

Exercise call options

Only the buyer of a call option can exercise a call option. It must, therefore, be a call long. It only makes sense to exercise the option if the share price or another underlying asset has risen above the strike price during the term of the option. To be more precise, a profit only arises if the price has risen so far that it also covers the option premium paid previously. See the profit and loss diagram:

The trading hours of the options exchanges or the deadline for acceptance by the relevant options broker are decisive for the exercise of options. Orders for options traded at Eurex must be received by Interactive Brokers by 6:00 p.m. CET on each Exchange day. For the CBOE in Chicago, the deadline is 16.30 EST (US Eastern Standard Time).

Holders of stock options must close out their positions before the expiration date if they wish to avoid the delivery of shares. The position is then closed out using a congruent offsetting transaction.

What must the seller of puts take into account?

Sellers of a put make a loss if, due to an actual fall in the share price, the stock has to fall at a higher exercise price than that available on the market, whereby the option premium received reduces the loss. If, on the other hand, the share price rises and the buyer does not exercise the put option, they make a profit in the amount of the option premium.

In practice, when an option is exercised, the underlying assets do not necessarily have to be delivered. In most cases, the differences between the exercise price of the option and the market price of the share or can be settled in cash via the clearinghouse. With many other underlyings, such as options on an index, commodities or interest rates, options are by their very nature only settled in cash (cash settlement).

Excursus 1: Making money with the sale of puts

By selling puts on stocks and indices, sellers can earn option premiums. Although this is not much compared to possible gains with an option from the underlying share price development, it has strategic potential, especially since the option premium is immediately credited as cash.

Warren Buffet, who mainly pursues his value investing strategy, collected USD 5 billion in option premiums between 2004 and 2008 simply by writing put options on the then-current share price as the strike price and was available to him as additional investment capital.

Buffet had mainly written long-term options with time splits of up to ten years. Since share prices have risen considerably in the meantime, he was able to retain a substantial portion of the option premiums.

The risk in selling puts is that the underlying shares actually have to be bought at a higher price than the market price or that the difference to the exercise price has to be settled in cash.

If you bet on falling prices, you can also buy a share at a lower price by selling a put long. It should be noted that the option premium previously received is deducted from the purchase price paid for the shares on delivery.

Excursus 2: Earn money with covered calls

It is also possible to earn money by writing calls (selling call options). The seller relies on stagnating or falling share prices. The prerequisite is that he already has the share in his possession (covered = covered).

If the share price falls, he can keep his shares because the buyer does not exercise the option. The option premium received reduces the loss in value of the shares in the seller’s portfolio.

If the share price stagnates, a profit in the amount of the collected option premium is incurred because the buyer of the call does not exercise the option either. He would not make a profit because of the premium paid. The profit for the seller of the covered call is limited to the option premium.

Only if prices rise will the buyer exercise the call. The risk is therefore that the seller of the option cannot take the increase in value of the shares on the market with him. However, he has received the option premium in return. If it is likely that prices will rise sharply, the investor can also buy back a corresponding call option. After deduction of the transaction costs, it may still be possible to take profits.

An actual loss would only occur if the shares were previously purchased at a higher price than the exercise price. A loss would also be incurred if the shares were not in the possession of the seller. However, this is impossible with the covered call strategy.

Read my other posts about options:

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