We mentioned in the previous lecture that exercising an option means the buyer exercises their right to buy or sell the asset.
A call option is the right to buy the underlying asset. Exercising a call option, means the holder of the call option exercises their right to buy the asset at the strike price of the option.
A put option is the right to sell the underlying asset. Exercising a put option, means the holder of the put option exercises their right to sell the asset at the strike price of the option.
Options can further be categorised as either European or American style. The main difference between the two relates to when the option can be exercised.
American style options can be exercised at any time before expiration. For example, assume a trader holds an American style call option of stock XYZ with a strike price of $50. That means they have the right to buy XYZ for $50 per share. As the option is an American style option, they can exercise that right at any point they choose before the option expires. In doing so they will then buy the stock at a price of $50 per share. So if the share price increased to $70 for example, the trader could exercise their $50 call option and buy the stock for $50 instead, saving $20 per share compared to buying the stock at the current market price.
European style options are only exercised at the moment they expire. For example, imagine the same stock and option as before, but this time it’s a European style call option of stock XYZ with a strike price of $50. They still have the right to buy XYZ for $50 per share, but because the option is European style, they cannot exercise this right until the moment of expiration. So if the share price increased to $70 before expiration as before, the trader cannot immediately exercise the option and buy the stock for $50 per share.
You may be thinking, why would someone choose to trade European options if they are forced to hold the option to the expiry date. This is a very common question of traders new to European options. The answer is that the option buyer is not forced to hold the European option to expiry. While they cannot exercise the option early, they can simply sell the option back to someone else. This will close their position and bank the profit. Doing this will normally result in a larger profit than exercising would have done anyway, due to something called extrinsic value.
Continuing with the European example, if the price of XYZ has increased to $70 but with time remaining before expiration, the European option buyer cannot exercise the option to buy XYZ at $50 per share yet. However, what they can do is sell the option to someone else. The value of this $50 call option will also be higher than the $20 difference between the $70 share price and the $50 strike price of the option (due to the extrinsic value we mentioned). It may be valued at say $22, giving the trader an extra $2 per share profit compared to exercising the option. This $2 extra is the extrinsic value. We will study extrinsic value in detail later in the course.
Summary
In summary, exercising an option means exercising the right described in the contract, i.e. buying or selling the asset at the strike price. The right given to the buyer of a European option can only be exercised at expiration, whereas the right given to the buyer of an American option can be exercised at any time.
Closing an option position by buying or selling the option (thereby reducing the outstanding position to zero), is different to exercising the option. With both European and American style options, the option can be bought and sold freely before expiration. This means traders of both European and American style options are able to close or adjust their positions before expiration.