Ways to Exercise Stock Options
Stock options are financial contracts that trade publicly in the open markets. An option lets its buyer know in advance how much she will pay to buy shares of stock, or receive to sell shares of stock, regardless of the stock's actual price at that time. You can buy and sell the stock options themselves, trading them like stock, or you can invoke the privileges of the contract and exercise the option to make a real stock trade.
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Exercise
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The majority of the trading volume of stock options is not by participants who actually wish to buy or sell real stock. Rather, they trade the options directly, profiting from fluctuations in the option prices. But as options are contracts tied to real stock, some strategies do result in an actual stock purchase. Whenever you own a stock option and use its terms to make a stock transaction, you are exercising the option. When you do this, you no longer own the option. Instead, you end up with shares of real stock, or you end up selling stock you already owned.
Discretionary Exercise
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One way to exercise a stock option is to simply inform your broker that you plan to do so. This is usually a feature contained in brokerage software, and it involves little more than pressing a button. If you are exercising call options, you must have enough capital to cover the purchase of 100 shares of stock for each option contract you exercise. If you exercise put options, you must own 100 shares of stock for each option. In both cases, you no longer own the option contract after the exercise; thus, you cannot sell it later. If you exercised a call, your brokerage account now contains shares of real stock. If you exercised a put, you no longer own the affected shares, and instead receive cash for the sale.
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Auto-Exercise
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After a certain date, specified with each option, the option contract ceases to exist and has no value. Most brokers understand that an option may actually have value on its last day of life, even if the option holder has failed to exercise it. As a result, if no action is taken, this value results in a 100 percent loss of the option's worth. Thus, most brokers have an auto-exercise policy in place. This is another way to exercise an option, and requires no action on your part. While the policies vary among brokers, if an option is valuable on its expiration day, a broker may automatically exercise it for you at the end of the day if you take no action yourself. The following day, you would see either real stock or new cash in your account.
Assignment
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Buying an option affords you the right to exercise that contract. However, option traders may also short options, which means they sell an option they do not already own. This is called writing the contract. If the buyer of your written contract chooses to exercise the option, then you are, what's called, assigned. If you wrote a call, you now transfer your own shares of stock to the option holder, in receipt for his cash. It is important to understand the relationship between option exercise and assignment. As an option buyer, you are not obligated to exercise an option. But as an option writer, you are obligated to assignment should your written option be exercised. As such, auto-exercise policies often lead to your auto-assignment.
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