Call options provide you with the right to buy shares of a certain stock, and when you exercise the option, you actually buy the shares. After you tell your broker to exercise an option, you have a few days to deposit the money into your brokerage account to pay for the shares. With the right type of account, it's possible to exercise and then sell the shares without coming up with the cash to actually pay for them, but it's not a good idea.
Even though you will have three days to pay for your call option shares, you may not sell them before settling your balance. Avoiding payment through such means is known as "free riding" and can result in penalties from your broker.
Exercising a Call Option
People often choose to exercise a call option when the underlying stock price is above the strike or exercise price on the option. The decision to exercise lets you buy shares at the lower strike price, resulting in an automatic profit on the shares – at least on paper.
For example, if the stock price is above the strike price when the option expires, the option will often automatically be exercised and the shares will be in your brokerage account on Monday, following the Friday expiration. Although in-the-money options are often set up to be exercised automatically, you as the option owner can always specify other conditions of sale. The choice to exercise is entirely in your hands.
Understanding Stock Settlement
Whenever you purchase stock, settlement rules give you three business days to pay for the shares. This means that when you choose to exercise, it is not necessary to have the money to pay for the shares in your account at that moment. You can take a couple of days to transfer the money to your broker. If you have a margin brokerage account, you can use a margin loan to pay for one-half of the cost and you need to deposit or have account equity for the other half before the trade settles.
Flipping The Shares
With three days to pay for your call option shares, you might think you could just sell the shares before the three days and never have to pay for them. You could probably get away with this – once. In a cash account, selling shares that have not settled and been paid for is called "freeriding," which is prohibited. If you do freeride, you broker has the right to freeze your account for 90 days.
In a margin account, you could flip the shares if you have enough available equity to cover half of the cost of the shares. If you do not have enough equity, selling the shares without paying for them violates Securities and Exchange Commission Regulation T, and your account will be tagged with a "liquidation violation," which could lead to trading restrictions if it happens again.
Selling the Call Options
If your call option is in-the-money with the stock price above the exercise price, you can lock in that equity by just selling the option to someone else. In other words, there really is no need to exercise the option, receive the shares and quickly sell them.
A better reason to exercise a call would be to obtain the shares as a longer term investment, but if you do not have the money to pay for the shares, that is not an option. If you choose to sell, you can sell your call options at any time until the market closes on the expiration Friday.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.