Strategies and Techniques

Exercising American Options

As I mentioned above, despite the fact you can exercise American options at any time, this doesn’t necessarily work out your advantage. In fact, the only time it seems to be worthwhile is sometimes if the stock pays a dividend. I don’t mean that you should sit on the option until expiration without doing other things, but you can lock in or increase your gains by taking appropriate actions.

I’ll explain the more effective choices by using an example. Suppose you have an option (for 100 shares) in a company trading at $150 per share, your strike price is $140, and it’s two months to expiration. Your option is in the money, and you’re understandably tempted to exercise it now in case the stock price falls. If you exercise the option, you will be buying 100 shares at a total of $14,000, and the shares are worth $15,000. That’s $1000 profit less the original option cost.

The first thing you could consider is selling your option for more than $1000. An option is worth the sum of its intrinsic value and its time value, and the intrinsic value is $1000. With two months to run, the time value must be worth something, and you should check the value online. This is better than exercising your option and selling the shares straightaway for $1000 profit, or exercising your option and keeping hold of the shares, which may fall in value.

If you were going to exercise the option and keep the shares, you could instead invest the $14,000 you would have used to buy the shares at a risk-free rate of interest. If at expiration the stock price is still in the money, you cash in the investment and buy the stocks, and you’ve gained two months interest. If by the expiration date the stocks are trading at less than the strike price, you again cash in the investment, buy the stocks in the market and you profit by the interest and how much the stock was under the strike price.

If you were going to exercise the option and sell straightaway, because you think the stock price is bound to fall, you can instead lock in your gain and possibly make more by selling the stock short rather than exercising early. You will make money from your short position as the stock price falls, and if it goes below the strike price you would have made an extra profit. If it just drops to the strike price, the short position will have locked in your gains. If you are wrong, and the stock price continues to rise, then you can still exercise the option at expiration — your short position will have lost any additional gains you could have had, but you still make the same profit as if you had exercised the option early.

For a call option, the one time you might want to exercise early is if you can get a dividend as a stockholder — you have to consider how much the dividend may be, and how that compares with interest on the money you will use to buy the stocks. With a put option you might exercise early if the stock has tanked and is trading near zero with little likelihood of coming back up. The stock can’t go below zero, which limits any further gains, and if you exercise early you can put the money to good use earning interest.

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