To exercise an option is to use the right you bought: you convert the contract into stock at the strike price. Exercise a call and you buy 100 shares at the strike; exercise a put and you sell 100 shares at the strike.
Exercise is one side of a handshake. Somebody sold you that right, and the moment you exercise, that seller is assigned: your choice becomes their obligation. Most US stock options are American style, exercisable on any trading day up to expiration. Index options like SPX and XSP are European style: exercise happens only at expiration, and they settle in cash, no shares change hands at all.
Here is the part beginners get backwards: having the right to exercise almost never means you should use it early. A winning option has two exits, exercise it or sell it, and selling is nearly always worth more. The one moment choice disappears is expiration itself: an option still in the money at the bell is exercised for you, automatically.
The numbers
You bought one $105 call on a $100 stock for $3.00, so $300 left your account. The stock runs to $110 with three weeks still on the clock, and the option now trades at $6.21. Two ways to take the win:
- Exercise. You pay $10,500 to buy 100 shares at the $105 strike. The shares are worth $11,000, so the stock position starts $500 in your favor. Minus the $300 you paid: up $200. And you now need $10,500 of real cash to carry the shares.
- Sell the option. You collect $621. Minus the $300 you paid: up $321. No shares, no capital tied up, done.
Same option, same minute, and selling paid $121 more. That $121 is the extrinsic value, the time value still sitting in the premium. The market would have paid you for that remaining time; exercising hands it back for free.
Where it bites
Early exercise is a donation. A call on a stock that pays no dividend is always worth more sold than exercised: whatever extrinsic value is left dies the moment you exercise. The one honest exception is a call right before a large dividend, and even then only when the remaining time value is smaller than the dividend you would capture.
Exercise obligates the full amount, not the premium. The trade cost you $300; exercising it costs $10,500. If that cash is not in the account, your broker sells things for you, at whatever price the market offers. Know where the $10,500 comes from before you click, or just sell the option.
If you sell options, exercise arrives from the other side. Someone else's exercise is your assignment. It clusters in two places: the day before an ex-dividend date, and at expiration, when everything in the money is exercised automatically.
Go feel it
The sell-versus-exercise choice exists because an option's price carries time value, and the way to build a gut feel for time value is to watch it drain. Hold a play-money call through its final days in Lesson 4: The Clock Is Always Running, then stand on the other side of the handshake in The Premium Trap, where exercise is something that happens to you.
Related concepts: assignment · option premium · expiration