Trading Options: When to Exercise and Price Determination

Exercise? Optional! Options? Exercisable!

• Options are financial derivatives typically used for speculative day trading, portfolio hedging and potential short-term profits - they are often highly leveraged and are not suitable for long-term investments.
• Options give you a choice to buy or sell the underlying asset (e.g. a share) at a stated price, called the strike price, before or on a predetermined date.
• When you can exercise the option can differ. While every option has a predetermined date, whether you can exercise it only on the date itself or any time before the date is dependent on the type of option you have bought.

American Option vs European Option

When Can You Exercise the Option?

When you can exercise the option can also differ. While every option has a predetermined date, whether you can exercise it only on the date itself or any time before the date is dependent on the type of option you have bought.

American Option: the option can be exercised any time before the predetermined date, which acts as an expiration date.

European Option: the option is only exercisable on the predetermined date itself, which acts as a maturity date.

As there is more flexibility in American Options, they will typically cost more than their European counterparts and thus have higher premiums.

In Singapore, most brokers offer access to American markets, so you will often see American Options in your brokers’ interfaces. However, Singapore’s own substitution for options, also known as Structured Warrants, bears a resemblance to European Options instead.

Value of Options

Not all investors keep options until their maturity/expiry date. Options traded on an exchange can be bought and sold at any time. Like other financial derivatives, options themselves have a value and can be traded like shares and bonds for a profit.

The value of options consists of two important components:

1) Intrinsic Value: this is the option's payoff if you exercise it now, i.e. Market Price - Strike Price for call options and Strike Price - Market Price for put options.

2) Time Value: this is associated with the possibility that the intrinsic value may increase or decrease before the expiration date. As the underlying asset price will continue fluctuating during this period before expiration, there is a chance for the value of the option to rise (or fall). Time value decays with the passage of time. (Also note that the volatility of the underlying asset will help to determine the value of the option.)

EXERCISING OPTIONS. COMPLETED. ✅

Sources:

1. https://www.ig.com/sg/options-trading/what-are-options-how-do-you-trade-them
2. https://www.investopedia.com/terms/o/option.asp
3. Header photo by Unsplash