Exercising vs. Selling an Option to Buy Shares
Is there an advantage to exercising options to buy shares?
Good morning!
Over the weekend, I had a viewer comment on my “Why Options Are Rarely Exercised” video and make the case that exercising a call option to buy shares at the strike price is better than selling the option and then buying the shares at the market price of the shares.
The viewer started with the following comment:
Scenario: You buy a call option with a strike price of $100 for $5, and the stock surges to $120 at expiration, is it better to exercise the call to buy the shares at $100/share, or can you sell the option and buy the shares at $120/share with the same result?
If you want the shares, you can simply allow the in-the-money call option to expire in-the-money, resulting in buying 100 shares at the call’s strike price.
But as a thought experiment, let’s compare the two scenarios:
So if you paid $5 for a $100-strike call option, your cost basis on the shares is $105/share if you exercise the call.
If you were to sell the call option for $20 and then immediately buy 100 shares at $120/share, you still get a $105/share cost basis because you made $15 on the call purchase.
The viewer didn’t agree:
And I thought this brought up a good point. The natural assumption is that buying shares at a lower price (the call’s strike price) is of course better than selling the option and buying the shares at a higher price.
But the math comes out the same:
If you buy a call option and the stock price surges, the option’s price embeds the profit that can be made by exercising it (purchasing the shares at the strike price instead of the stock price).
For example, if you buy a 200-strike call for $10 and the stock goes to $250, the 200-strike call will be worth $50 at least. The $50 minimum value, or intrinsic value, is what you can make by exercising the call to buy shares at $200/share when the stock is currently trading for $250/share.
And so if you exercise the option, you’ll capture that gain and own the shares.
Of course, if you own an in-the-money call and you wish to take the shares because you’re bullish on the stock, then allowing the option to expire ITM is easier than selling the option and buying the shares in a separate transaction.
But as a learning exercise, the math comes out the same in both scenarios outlined above. There may be taxation differences, but I am no tax expert.
-Chris
What about Tx costs? Some brokers may charge to close the position and wouldn't you would then have the Tx cost of purchasing the shares? I know you're not a tax guy but isn't part of the appeal of trading options vis a vis shares the preferable tax treatment that options get vs short-term capital gains on trading stock?