The purpose of this article is to throw some light on the financial logic behind the Option trading & investors’ decision to exercise or to allow the option to expire. We would discuss the logic taking an example of Equity or Stock Option in which the underlying instrument of the Option is an equity share.
Option exercise means the buyer of the option chooses to buy or sell the underlying instrument of the option contract depending upon the nature of option, either Call or Put respectively.
When a call option is exercised the buyer of the call option calls for the underlying security from the option seller i.e. the buyer of a call option buys the underlying security & the seller has to deliver the same to the buyer at a pre decided strike price.
When a put option is exercised the buyer of the put option puts the underlying security i.e. the buyer of the put option sells the underlying security at strike price & the seller of the option has to buy the same at that price.
To understand the logic behind why a particular option contract is exercised or not first we need to understand why the Option contract is entered into.
Following are the possible trades in an Option trade
•Buy a Call Option
•Buy a Put Option
•Sell a Call Option
•Sell a Put Option
Buying is going Long & Selling is going short. Hence we would have following possibilities of option trades corresponding to each of the above mentioned possible trades.
Example: Suppose we have an Equity Option having Stock X as underlying security. Suppose the current market price of Stock X is $75. The Option on Stock X is trading at $10 Premium with a Strike Price of $80.
Going Long on Call:
A trader who is optimistic about the future price of the stock X has a feeling that stock X would appreciate in near future. He would buy a right to purchase the Stock X i.e. a call option on Stock X instead of buying the Stock X itself. If the difference between the market price of stock X at expiry of the Option & the strike price is more than $10 (the option premium already paid) the trader would make a profit.
Option exercise means the buyer of the option chooses to buy or sell the underlying instrument of the option contract depending upon the nature of option, either Call or Put respectively.
When a call option is exercised the buyer of the call option calls for the underlying security from the option seller i.e. the buyer of a call option buys the underlying security & the seller has to deliver the same to the buyer at a pre decided strike price.
When a put option is exercised the buyer of the put option puts the underlying security i.e. the buyer of the put option sells the underlying security at strike price & the seller of the option has to buy the same at that price.
To understand the logic behind why a particular option contract is exercised or not first we need to understand why the Option contract is entered into.
Following are the possible trades in an Option trade
•Buy a Call Option
•Buy a Put Option
•Sell a Call Option
•Sell a Put Option
Buying is going Long & Selling is going short. Hence we would have following possibilities of option trades corresponding to each of the above mentioned possible trades.
Example: Suppose we have an Equity Option having Stock X as underlying security. Suppose the current market price of Stock X is $75. The Option on Stock X is trading at $10 Premium with a Strike Price of $80.
Going Long on Call:
A trader who is optimistic about the future price of the stock X has a feeling that stock X would appreciate in near future. He would buy a right to purchase the Stock X i.e. a call option on Stock X instead of buying the Stock X itself. If the difference between the market price of stock X at expiry of the Option & the strike price is more than $10 (the option premium already paid) the trader would make a profit.
Suppose the actual market price of Stock X at the expiry of the Option is $97 the Option would still give a right to the trader to buy the Stock at $80 (the strike price). The buyer would exercise the option to buy the Stock X at $80 & may sell the same in the market at $97. His profit would be $97 minus ($80+$10) = $7 per share.
In contrast to this if the actual price of the stock at the time of expiry goes down the trader would not exercise the option but would prefer to let the option expire.
Going Long on Put:
Take an example of a trader who is bearish about Stock X price & expect that the price is going to fall in near future. He would buy a Put Option i.e. a right to sell the stock at a pre decided price (strike price). If the actual price of Stock X at option expiry is decreased below the exercise price by more than the premium paid ($10 in our example), the trader would make a profit.
Going Long on Put:
Take an example of a trader who is bearish about Stock X price & expect that the price is going to fall in near future. He would buy a Put Option i.e. a right to sell the stock at a pre decided price (strike price). If the actual price of Stock X at option expiry is decreased below the exercise price by more than the premium paid ($10 in our example), the trader would make a profit.
Suppose the actual price of Stock X at the expiry of the option is $65 the trader would exercise the option to sell Stock X at $80 (strike price as per above example) making a profit of $5 per share i.e. $80 minus ($65 +$10). To make the logic clear here please note that even though the trader might not have a Long position (number of units of Stock X required for exercising Put Option) he could buy the shares from market at $65 & Sell them at $ 80.
If the price of Stock X at expiration of the in fact increases, the trader would not exercise the Put option as he may earn more by selling the stock in the market instead of selling it under the Option contract.
Going Short on Call:
Any Option buyer has a corresponding Option Seller. In above discussion on Going Long on Call the buyer of the Call option is optimistic about the price of Stock X. He buys a Call Option on Stock X. The corresponding Counterparty would in fact be Selling a Call Option with exactly opposite expectation about the price of Stock X. This Selling of Call Option is called as Going Short on Call. Here the trader expects that the price of the stock would fall. If the actual price at the expiry of the Option decreases the Option Seller would earn a profit equal to the premium paid to him. But if the price increases the Buyer of the call option would require the Seller to sell the security to him & the loss could be unlimited to the Seller.
Going Short on Put :
A trader who anticipates that the stock price will increase could sell a put option to another trader who is expecting the price of the stock to decrease. If the actual price of Stock X at the expiry is above the exercise price, the trader going short put would earn a profit equal to the amount of the premium received. If on the other hand the stock price is below the exercise price by more than the amount of the premium, the trader will make a loss.
To summarize our discussion we can say that Option mechanism is usually of complex nature & whether an Option would be exercised or expire without exercise would depends upon the expectations of the traders & the actual outcome of the market.
Going Short on Call:
Any Option buyer has a corresponding Option Seller. In above discussion on Going Long on Call the buyer of the Call option is optimistic about the price of Stock X. He buys a Call Option on Stock X. The corresponding Counterparty would in fact be Selling a Call Option with exactly opposite expectation about the price of Stock X. This Selling of Call Option is called as Going Short on Call. Here the trader expects that the price of the stock would fall. If the actual price at the expiry of the Option decreases the Option Seller would earn a profit equal to the premium paid to him. But if the price increases the Buyer of the call option would require the Seller to sell the security to him & the loss could be unlimited to the Seller.
Going Short on Put :
A trader who anticipates that the stock price will increase could sell a put option to another trader who is expecting the price of the stock to decrease. If the actual price of Stock X at the expiry is above the exercise price, the trader going short put would earn a profit equal to the amount of the premium received. If on the other hand the stock price is below the exercise price by more than the amount of the premium, the trader will make a loss.
To summarize our discussion we can say that Option mechanism is usually of complex nature & whether an Option would be exercised or expire without exercise would depends upon the expectations of the traders & the actual outcome of the market.
I hope this article would be helpful to understand the basic logic behind the option exercise. Although I have not discussed the Option trading from hedging & speculating perspective my coming articles would take care of this.
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