A call option gives the investor the right to buy stock, but not the obligation. It’s a contract that agrees to let you buy at a set price (called the strike price) for a certain limited time until its expiration date.
For the investor who holds a call option, hopefully the underlying value of the stock will go up. If the asset value rises above the strike price, you can exercise the option and buy stock at the original (strike) price. This means that you’re getting the stock well below current market value. So, the easy answer is that you should exercise when it rises above strike price.
However, exactly when you should exercise and buy the stock depends on market conditions. Will its underlying value continue to rise? If so, you may choose to wait longer before exercising. The price will be higher and you’ll still get it at that agreed upon price.
You also need to consider the implications on your capital if you exercise the option. Once exercised, you will need to buy 100 x the number of option contracts bought of shares at the strike price. If you do this, be sure you have enough capital in your account to make this trade.
Another alternative if the call option is in-the-money is to trade out of the option directly by selling those option contracts back in the market. Doing this still locks in the profits of the option without requiring additional capital. However, doing this incurs more transaction costs in the form of brokerage and exchange fees.
As soon as you tell your broker that you’d like to exercise, the process of buying the stock begins. When you exercise a call option, you get 100 shares in the stock per option contract. After exercising and buying the stock, you may choose to turn around and sell it. This is a way to make instant profit on your exercised call option. Investors choose to sell call options because they either don’t expect it to continue rising in value or they’re happy to make money on the premium.
Another option is to hold onto the stock if you anticipate that it will continue to rise in value. If the value begins to drop, you can sell the stock immediately and, if your call option strike price is still below the current market value, you’ll still come out ahead. This is the major benefit of options; they leverage risk in a changeable market.
When discussing call options, we often speak of investors ‘going long’ or ‘going short.’ Basically, ‘going long’ means buying a call option. When you sell a call option, it’s called ‘going short.’ This refers to the time left before the option expires.
You should only exercise a call option when you stand to make a good profit. For each transaction, you pay a commission to the broker. You then pay more fees when you sell the stock. This is pointless unless it’s going to garner you a good profit.
Many financial specialists advise against exercising a call option just to turn around and sell the stock. The reason is that it invites unnecessary risk. Stock prices can change drastically from day to day. There is also what’s called ‘weekend risk,’ where an investor exercises a call option on Friday with the intention of selling the stock Monday. A lot can happen in two days. Most financial advisors recommend only exercising if you’re going to hang onto the stock for a while.
There really is no easy answer to when is a good time to exercise a call option. It all depends on your investing strategy, current market conditions and a number of other factors.