Understanding Call and Put Option Exercises: Rights and Obligations
When dealing with options, the exercise of a call or put option can significantly impact both the holder and the seller. In this guide, we will explore what happens when these options are exercised, the obligations involved, and the rules surrounding the exercise process.
Call Option: A Right to Buy
Definition: A call option grants the holder the right, but not the obligation, to purchase a specified amount of an underlying asset (such as stocks) at a predetermined strike price before or at the expiration date.
When Exercised: Upon exercising, the holder buys the underlying asset at the strike price, while the seller or writer of the call option is obligated to sell the asset at that price.
For example, if an investor exercises a call option with a strike price of $50 when the market price is $70, they can purchase the asset for $50, potentially realizing a profit of $20 per share. It is essential to note that exercising a call option is only favorable when the strike price is less than the market price.
Put Option: A Right to Sell
Definition: A put option grants the holder the right, but not the obligation, to sell a specified amount of an underlying asset at a predetermined strike price before or at the expiration date.
When Exercised: When a put option is exercised, the holder sells the underlying asset at the strike price, and the seller or writer of the put option is obligated to buy the asset at that price.
For example, if an investor exercises a put option with a strike price of $50 when the market price is $30, they can sell the asset for $50, potentially realizing a profit of $20 per share. Exercising a put option is beneficial only when the strike price is greater than the market price.
Exercise Process and Settlement Rules
The price of an option at the time of exercise is determined by the option's strike price, regardless of any fluctuations in the market. Settlement is conducted according to specific rules:
T2 Rule (Effective 2017): The general rule for most securities is T2, meaning that trades are settled two business days after the trade date.
T3 Rule (Prior): Before 2017, the settlement rule was T3, which required settlement three business days after the trade date.
Options Settlement: Options have a special rule known as T1, meaning they settle on the next business day.
Example of a Call Option Exercise
Fred, an investor, holds a call option with a strike price of $50 that he can exercise before expiration. On the exercise date, the market price of the underlying asset is $70. If the call option is in the money (strike price
Expiration and Unexercised Options
If an option expires unexercised, the holder loses their rights inherent in the contract, including the premium they paid for the option.
Expiration of Call Options: If the market price is below the strike price, the call option will not be profitable to exercise, and it will expire worthless.
Expiration of Put Options: If the market price is above the strike price, the put option will not be profitable to exercise, and it will also expire worthless.
In conclusion, understanding the exercise, rights, and obligations of call and put options is crucial for effective trading and risk management. It is important to know the strike price, market prices, and the exercise rules to make informed decisions when dealing with options.