Exercise
Exercise
The act by which an option holder (buyer) invokes their right to buy (for calls) or sell (for puts) the underlying security at the strike price. Only the option holder can exercise; the seller cannot. Call exercise means buying at the strike price; put exercise means selling at the strike price. Exercise typically occurs when options are in-the-money, though holders can choose to exercise any time before expiration. Upon exercise, the option seller is assigned and must fulfill the obligation (deliver shares for calls, buy shares for puts). Exercise settlement is typically T+1.
An investor owns a call option on XYZ stock with a $50 strike price. XYZ is currently trading at $58. The investor exercises the call, purchasing 100 shares at $50 (the strike price) even though the market price is $58, immediately gaining $8 per share in intrinsic value. Conversely, if an investor owns a put option with a $45 strike and XYZ falls to $38, exercising the put allows them to sell shares at $45 instead of the current $38 market price, capturing the $7 difference.
Students often confuse exercise with assignment: exercise is the holder's (buyer's) action to use their right, while assignment is what happens to the seller when the holder exercises. Another common error is thinking the seller can exercise (only the holder can). Many also confuse which direction exercise goes: call exercise means buying at strike (not selling), put exercise means selling at strike (not buying). Additionally, students sometimes think you must exercise in-the-money options, but holders can choose not to exercise or can even exercise out-of-the-money options (though this is economically irrational). Finally, confusing exercise with closing a position: you can close an option by selling it back, which is different from exercising it.
How This Is Tested
- Identifying who can exercise an option (holder/buyer only, never the seller/writer)
- Determining what happens when a call option is exercised (holder buys at strike price)
- Determining what happens when a put option is exercised (holder sells at strike price)
- Calculating profit or loss from exercising an option given market price and strike price
- Understanding when it makes economic sense to exercise (typically when in-the-money)
- Distinguishing between exercise (holder's action) and assignment (seller's obligation)
- Recognizing that exercise is the holder's choice, not requirement, even if in-the-money
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Exercise settlement period | T+1 (1 business day) | Stock delivery occurs one business day after exercise |
| Exercise cutoff time (equity options) | 5:30 PM ET on expiration day | Varies by broker; some use earlier cutoffs |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Maria owns a call option on ABC stock with a strike price of $60, for which she paid a $3 premium. ABC is currently trading at $67, and the option expires tomorrow. Maria is considering her options. Which action would be most economically rational?
B is correct. Exercising the call allows Maria to buy shares at the $60 strike price when the market price is $67, immediately capturing $7 per share in intrinsic value. Since the option expires tomorrow, exercising now locks in this value. After exercise, she could sell the shares at $67 for a net profit of $4 per share ($7 gain from exercise minus $3 premium paid).
A is incorrect because letting an in-the-money option expire worthless throws away $7 of intrinsic value. The $3 premium is a sunk cost and should not influence the decision to capture the $7 currently available. C is incorrect because the $63 breakeven ($60 strike + $3 premium) was relevant when deciding whether to buy the option initially, but now that the premium is paid (sunk cost), the only question is whether exercising captures value. At $67, exercising captures $7, which exceeds the $3 cost. D is incorrect because the option holder does not need permission to exercise; exercise is the holder's unilateral right.
The Series 65 exam tests whether you understand when exercising makes economic sense. The key principle is that you should exercise when the option is in-the-money, regardless of the premium already paid (sunk cost). You must also understand that exercise is the holder's right and does not require seller permission or approval.
Which of the following accurately describes the exercise of an option contract?
B is correct. Exercise is the action taken by the option holder (buyer) to invoke their contractual right to buy the underlying security (for call options) or sell the underlying security (for put options) at the predetermined strike price. Only the holder can initiate exercise.
A is incorrect because the option seller (writer) cannot exercise; they can only be assigned when the holder exercises. The seller has an obligation, not a right, and does not initiate exercise. C is incorrect because exercise does not happen automatically; it is the holder's choice. While most in-the-money options are exercised at expiration, the holder must still make the decision to exercise (or their broker may auto-exercise deep in-the-money options per their instructions). D is incorrect because closing an option position by selling it in the secondary market is different from exercise. Selling the option transfers the right to someone else; exercising the option invokes the right to buy or sell the underlying.
The Series 65 exam frequently tests the fundamental distinction between exercise (holder's action) and assignment (seller's consequence). You must understand that only the holder can exercise, that exercise is voluntary (not automatic), and that exercise differs from simply selling the option back to close the position.
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Access Free BetaAn investor purchased a put option on DEF stock with a $55 strike price, paying a $4 premium per share. DEF is currently trading at $48. If the investor exercises the put option today, what is the net profit or loss per share?
B is correct. Calculate the profit from exercising the put: The investor exercises the put to sell shares at the $55 strike price when the market price is only $48, gaining $7 per share from exercise ($55 - $48 = $7). Subtract the $4 premium paid initially to get the net profit: $7 - $4 = $3 profit per share.
A ($3 loss) incorrectly subtracts the intrinsic value from the premium ($4 - $7 = -$3) instead of the other way around. C ($7 profit) calculates the intrinsic value from exercise ($55 strike - $48 market) but forgets to subtract the $4 premium cost. This represents gross profit, not net profit. D ($11 profit) incorrectly adds the premium to the intrinsic value ($7 + $4 = $11) instead of subtracting it. The premium is a cost, not a gain.
The Series 65 exam tests your ability to calculate net profit from exercising options. The formula is: Net Profit = Intrinsic Value from Exercise - Premium Paid. For puts, intrinsic value = Strike - Market Price (when market is below strike). You must remember to subtract the premium cost to get net profit, not just calculate the intrinsic value from exercise.
All of the following statements about exercising options are accurate EXCEPT
C is correct (the EXCEPT answer). This statement is FALSE. Option holders are not required to exercise in-the-money options; exercise is always the holder's choice. While it is economically rational to exercise (or sell) in-the-money options to capture intrinsic value, the holder can choose not to exercise for various reasons (tax considerations, not wanting the underlying stock, preferring to close the position by selling the option instead, etc.). Many brokers offer automatic exercise for deep in-the-money options at expiration, but this is based on the holder's instructions, not a requirement.
A is accurate: only the option holder (buyer) can exercise. The seller (writer) has an obligation, not a right, and cannot initiate exercise. B is accurate: exercising a call option means the holder purchases the underlying security at the strike price, regardless of the current market price. This is how call holders profit when the market price exceeds the strike price. D is accurate: when a holder exercises an option, the Options Clearing Corporation (OCC) randomly assigns a seller who must fulfill the obligation (deliver stock for calls, buy stock for puts).
The Series 65 exam tests whether you understand that exercise is voluntary, not mandatory. While economically rational holders typically exercise in-the-money options, they are not required to do so. You must distinguish between what is smart strategy versus what is required by regulation. This also tests whether you understand the difference between automatic exercise features (broker convenience) versus regulatory requirements.
An investment adviser is explaining option exercise mechanics to a new client. Which of the following statements about exercise are accurate?
1. Exercising a call option requires the holder to buy the underlying at the strike price
2. Exercising a put option requires the holder to sell the underlying at the strike price
3. The option seller can choose to exercise if market conditions are favorable
4. Exercise typically makes economic sense when the option is in-the-money
B is correct. Statements 1, 2, and 4 are accurate.
Statement 1 is TRUE: When a call option holder exercises, they are invoking their right to buy (purchase) the underlying security at the predetermined strike price. For example, exercising a call with a $50 strike means buying shares at $50, even if the market price is $60.
Statement 2 is TRUE: When a put option holder exercises, they are invoking their right to sell the underlying security at the strike price. For example, exercising a put with a $45 strike means selling shares at $45, even if the market price is only $40.
Statement 3 is FALSE: The option seller (writer) cannot choose to exercise. Only the option holder (buyer) can exercise. The seller has an obligation (not a right) and can only be assigned when the holder decides to exercise. The seller cannot initiate exercise, regardless of market conditions.
Statement 4 is TRUE: Exercise typically makes economic sense when the option is in-the-money, meaning it has intrinsic value. For calls, this means market price > strike price; for puts, this means market price < strike price. Exercising out-of-the-money options results in immediate loss compared to buying/selling at market prices.
The Series 65 exam tests comprehensive understanding of exercise mechanics, including the direction of transactions (calls = buy, puts = sell), who can initiate exercise (holder only), and when exercise is economically rational (in-the-money). You must clearly distinguish between holder rights (exercise) and seller obligations (assignment), and understand that calls and puts work in opposite directions.
💡 Memory Aid
Exercising your right = Using a coupon you own: Just like only you (not the store) can choose to use your coupon, only the option holder (buyer) can exercise. Call exercise = Buy at strike (you "call to come buy"). Put exercise = Sell at strike (you "put it away by selling"). Think: "EX-ercise = EX-ecute the right" (but only if you're the holder, not the seller).
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This term is part of this cluster:
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Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: