You can use options to both prevent portfolio losses and to speculate on market prices. Call and put option contracts give you the right to buy and sell the underlying shares at specified prices, known as strike prices, before predetermined expiration dates. You do not have to exercise these rights if you decide to sell the options. When you exercise a call option, you would buy the underlying shares at the specified strike price before expiration.
Compare the strike price of the call option to the current stock price. You would exercise your rights and buy the shares only if the call option is in the money, meaning the strike price is less than the stock price. For example, if the strike price is $20 and the stock price is $15, exercising would not make sense because you can buy the shares for $5 less than the strike price.Step 2
Review the company fundamentals, such as earnings growth and consistent cash flow. You should be able to find the relevant information in quarterly financial statements posted on the company's investor relations website. If the fundamentals are sound and the outlook is bright, you could exercise your call options and hold on to the shares for long-term capital gains.Step 3
Compare the profits from selling your call options versus exercising them. For example, calls bought at 50 cents a contract when the share price was $20 could be worth 60 cents if the share price rises to $25. Your profits would be 10 cents a contract if you were to close out the call position, which is a 20 percent return on investment. If you were to exercise your rights, buy the shares for $20 and then sell them for $25 each, your profits would be $5 a share, which is a 25 percent return on investment.Step 4
Exercise call options if you are using them to hedge a short sale and the stock price continues to rise. A short sale involves selling shares that you borrow from your broker in the expectation that you can buy them back at lower prices. If the stock rallies instead, call options with the appropriate strike price could prevent losses because you could exercise the calls to cover your short position. For example, if you simultaneously sold short a stock at $20 and bought call options with a strike price of $20, you could exercise the calls to cover your short position if the stock price rallies past $20.
- The Options Clearing Corporation automatically exercises options if they are in the money by one cent or more. Your broker may have different procedures for automatic exercises.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.