Selling an Option vs Exercising It: Which Strategy is Right for You?

One of the dilemmas in options trading is deciding between selling an option vs exercising it. This article sheds a light on the pros and cons of selling an option vs exercising it. We’ll tackle the question, “Is it better to exercise an option or sell it?” or “What is the difference between exercising and selling an option?” while considering various scenarios and factors. Exercising an option vs selling it requires a thorough analysis, let’s find out more about it.

Key takeaways

• Selling an option vs exercising is a process requiring you to evaluate different market scenarios. Specifically, you will need to make different considerations, whether it is out-of-the-money (OTM) or in-the-money (ITM).
• If your option is Out-of-the-Money (OTM), the optimal choice is almost always to sell it. This is because OTM options typically have little intrinsic value, and assigning options means that you will buy/sell the shares at a worse price than you can get in the market.
• If the options are ITM, you might want to assign the options – especially if there is a dividend/Spinoff before expiration. If there is still time value in the options and no event, you probably want to sell the option.

Selling an Option vs Exercising It: Weighing the Pros and Cons

What is the difference between exercising and selling an option? In the world of options trading, the dilemma of selling an option vs exercising it is a common one. Both strategies have their own merits and drawbacks, and understanding these can help traders make informed decisions that align with their objectives and risk tolerance.

The primary difference between exercising and selling an option lies in the actions involved. Exercising an option means utilizing the rights granted by the contract to buy or sell the underlying asset at the predetermined strike price. Conversely, selling an option involves closing the position through an offsetting transaction before its expiration.

Selling an option vs exercising it presents distinct advantages and disadvantages. When you exercise an option, you stand to benefit from potential price hikes in the stock. However, this strategy requires owning the underlying shares and could lead to loss of any remaining time value if the option still has it. On the other hand, selling allows you to capitalize on the remaining time value without the need for owning the underlying shares.

To illustrate this, consider two real-life scenarios: If you own a call option that’s deep in the money and the stock pays a significant dividend, exercising to capture the dividend might be a smart move. But if the option is out of the money or still holds time value, selling could be a more profitable choice.

So, is it better to exercise an option or sell it? Let’s find out below.

Factors to Consider When Deciding Selling an Option vs Exercising It

The decision between selling an option vs exercising it often comes down to the current market scenario and the specific condition of your option. Whether your option is Out-of-the-Money (OTM) or In-the-Money (ITM) plays a significant role in this decision.

When an option is OTM, selling it is usually the optimal choice. This is because OTM options have no intrinsic value, and selling them allows you to recover some of your initial investment. Additionally, assigning OTM options usually means you buy/sell shares at a worse price than currently available in the market,, making the question “Is it better to exercise an option or sell it?” rather moot in this situation.

However, when dealing with ITM options, the answer to “What is the difference between exercising and selling an option?” becomes more nuanced. Several factors come into play, including time value remaining, dividends, or spinoffs. If the ITM option has little or no time value left or if there are dividends or spinoffs considerations, exercising the option can be beneficial.

But if these factors don’t apply, selling the ITM option might be a more sensible choice. So, the debate over exercising an option vs selling or selling an option contract vs exercising is highly dependent on your unique circumstances.

Who Should Exercise an Option?

While selling an option before the expiration may be generally recommended, certain types of traders and specific circumstances may make exercising the better choice. Remember, selling an option vs exercising it is a decision that should be based on your overall trading strategy and objectives.

Long-term investors and dividend-seeking investors for example, may find value in exercising an option. This strategy allows them to acquire the underlying stock at a predetermined price, which could align with their long-term investment goals.

A Typical Use Case Where You Should Exercise an Option

Let us consider, for the sake of clarity, a case in which you own a call option for a company that regularly distributes dividends. Assume that the strike price of the option is $34, while the stock is trading at $34.27 (note that, in this case, you own an in-the-money option). Assuming that the market price of the call contract is $0.3, you’re technically investing $0.3*100 shares, which equals to $30. The cash amount required to buy 100 shares at $34 is $3,400.

So, we could say that the time premium in this case is equal to $3. Why is that? To obtain this value, you should consider $34 + $0.3 on one side (i.e., $34.3) and the stock price (i.e., $34.27). The difference between these two values is $0.03 which, if multiplied by 100 shares, equals to $3.

As the table below summarizes, you find yourself with a total amount of $3,430 before the ex-date.

Now let’s assume that this company distributes a dividend of 67$ (0.67 per share)

At this point, there are two scenarios:

1. You take no action: here, you may assume that the value of your option will decrease to $0.04 (hence $0.04*100 shares equals $4) as the option now becomes OTM. This leaves you with a total value of $3,404.
2. You exercise the option: here, we consider the original stock price ($34.27) minus the known dividend ($0.67), so the price of the stock after div is $33.6 (or $3,360). If you sum the stock value to the dividend you cash in, you are left with $3,427.

If we compare the 2 scenarios: We see that TAKING ACTION – and exercising the option will lead to a higher ($23) profit compared with doing nothing.

Note that, interestingly, in the second case, you’d be only losing $3 compared to your initial $3,430 value. And, if you recall, $3 was exactly equal to the time premium of the option.

From here, we deduce an important rule: if the dividend is bigger than the time premium of the option, you should exercise the call and collect the dividend.

A Long Call Example on a Dividend-Paying Stock

Let’s consider Verizon (VZ), and suppose you have a bullish outlook on the stock. Currently, VZ is trading at $34.30 and, most importantly, we know that the company regularly pays out a dividend for its stock. Keep in mind that option holders do not have any right to dividends, but owning the underlying stock does. Exercising an option vs selling it could be a smart move in this case.

Let’s suppose that, using an option screener such as Option Samurai, you find the opportunity to set up a long call strategy on VZ. Specifically, you choose to buy a $34 call.

If you are right in your trade and the stock moves higher than $34 – in this specific case, Option Samurai would inform you that the breakeven price at maturity for the option trade would be $34.52 – then you may decide to exercise the option before expiration in order to buy 100 shares of VZ for each contract you own.

Note that, in this case, selling an option would give you a profit. However, if you’re a long-term investor, you’ll probably prefer give up a short-term profit for a potentially higher return when holding VZ shares.

Even better, if you managed to exercise the option before the ex-dividend date, you would get to collect a dividend that you wouldn’t have been entitled to if you had sold the call option instead. In this scenario, exercising the option was a more profitable choice than selling it.

Exercising an option vs selling it ultimately boils down to individual trading strategies and objectives. Factors such as the time value of an option, expiration date, desired ownership of underlying shares, stock prices, transaction costs, and margin exposure all influence this decision.

Who Should Sell an Option?

In the ongoing debate of selling an option vs exercising it, certain investors and scenarios make selling an option the superior strategy. Selling can align with specific investment strategies and goals, offering definitive benefits to traders.

Investors who are keen on capturing time value and avoiding additional expenses might find selling option contracts vs exercising an attractive idea. This strategy allows them to profit from the premium received without needing to own the underlying stock. As we explained in another post, you could even consider selling options after hours.

A Typical Use Case Where You Should Not Exercise an Option

Once again, we’ll leverage the use case we presented earlier and make a few edits to portray an ideal scenario where it is not worth exercising an option, even considering a dividend-paying company.

Let’s go back to that case: we have a $34 call option with a stock trading at $34.27. We know that the company will soon pay a $0.67 dividend per share. Our call price is, however, equal to $1, a relevant difference compared to the case we saw earlier. If we use the 100 shares multiplier, we have an investment equal to $100, which we can sum to $3,400 (the cash amount required to buy 100 shares of our company, just like we said earlier).

What is the time premium in this case? Let’s repeat the calculation we performed above: consider $34, the strike price, plus $1, the option price (i.e., $35). When comparing this value to the stock price ($34.27), we have a difference of $0.73. Remember, we still need to multiply the value by 100 shares, which leads us to the conclusion that the time premium of the option is $73.

Again, before the ex-date, the total amount involved in the operation would be $3,430. The table below will help us see all the scenarios:

You find yourself facing the same choice as before:

1. You take no action: you may assume that the value of your option will decrease to $0.5 (hence $0.5*100 shares equals $50), leaving you with a total value of $3,450. If you think about it, it’s a relatively logical assumption to think that, especially if we’re far from its maturity, the call option would have value in this case.
2. You exercise the option: let’s start from the original stock price ($34.27) and subtract the dividend ($0.67). The theoretical price would be $33.6 (or $3,360 when multiplied by 100), for a total value of $3,427.

The second case exactly corresponds to what we obtained earlier, with one major difference: now, the first scenario looks more profitable than the second (exercising the option). There is no magic involved here as, once again, the rule we mentioned earlier applies: whenever the time premium of the option is larger than the company’s dividend, it is not worth exercising an option and cashing the dividend amount.

A Long Call Example on a Stock that Does Not Pay Dividends

To help you better understand the advantages of selling, let’s consider an example involving Amazon (AMZN), which is a stock that does not pay dividends. In this case, we’ll assume you have a bullish outlook on the company, currently trading at $128.56.

In this case, you may want to choose buying a $129 put, believing that the stock price will enter an upward movement sideways movement.

Assuming you’re right in this intution, imagine the stock price moves up by 5% two days later, putting your option in-the-money. You could benefit from selling the call contract before it expires without owning any shares of AMZN. Keep in mind that Option Samurai would inform you that you’d need the stock price to be above $133.95 on the expiry date to be profitable, as illustrated below by the dotted line:

In this case, you may judge the price quick upward movement to be too sudden and significant, and, fearing a downward correction, you may decide to sell the option before it expires.

The process of selling an option vs exercising it requires careful evaluation of different market scenarios and your option’s current status. When your option is Out-of-the-Money (OTM), leaning towards selling often proves optimal as you recoup some initial investment, and you usually can just buy/sell the asset outright at a better price..

However, the question “Is it better to exercise an option or sell it?” becomes complex with In-the-Money (ITM) options. Here, exercising an option vs selling depends on several factors like remaining time value, dividends, or spinoffs.

If these factors are in play, consider exercising the option; if not, selling the ITM option might be a smart move. Understanding the difference between exercising and selling an option is key in making an informed decision when dealing with option contracts.