When you own a profitable option, you have two choices: exercise it to buy or sell the underlying shares, or simply sell the option to close your position. Many new traders assume exercising is the way to capture profits, but in most cases, selling the option is the financially superior choice. Let us explore why.
Understanding Your Choices
First, let us clarify what each choice means:
Exercising: Using your right to buy shares (for calls) or sell shares (for puts) at the strike price. This converts your option into a stock position.
Selling: Closing your option position by selling it in the market. You receive the current market price of the option and have no further position.
Why Selling is Usually Better
In most situations, selling your option captures more value than exercising. Here is why:
You Keep the Time Value
Every option has two components: intrinsic value (the amount the option is in the money) and time value (the extra premium for time remaining). When you exercise, you only capture the intrinsic value. When you sell, you capture both intrinsic AND time value.
Example: Why Selling Beats Exercising
You own a $95 call option on stock XYZ. The stock is trading at $100.
- Option intrinsic value: $5.00 ($100 - $95)
- Option time value: $1.50
- Total option value: $6.50
If you exercise: You buy shares at $95 and can sell them at $100, netting $5.00 profit per share.
If you sell: You receive $6.50 for the option, netting $6.50 profit per share.
By exercising, you left $1.50 per share on the table.
No Capital Requirement
Exercising a call option requires you to pay the full strike price to buy 100 shares. If you own a $100 call, you need $10,000 in your account to exercise. Selling the option requires no additional capital.
No Stock Risk
Once you exercise, you own shares that can decline in value. If the stock drops after you exercise, you can lose money on the shares. Selling the option locks in your profit with no further risk.
Simpler Execution
Selling is a single transaction. Exercising often involves multiple steps: the exercise itself, then deciding what to do with the shares. Selling is cleaner and faster.
When Exercising Makes Sense
Despite selling usually being better, there are specific situations where exercising can be the right choice:
1. Capturing Dividends
If you own a call option on a dividend-paying stock and the dividend is larger than the remaining time value, exercising before the ex-dividend date can make sense. You would own the shares and receive the dividend.
Example: Exercising for Dividend
You own a deep ITM call with only $0.20 time value remaining. The stock pays a $0.75 dividend tomorrow.
- If you sell: You get the current option value
- If you exercise: You get the shares plus the $0.75 dividend
- Since $0.75 > $0.20, exercising captures more value
2. You Want to Own the Stock
If your goal is long-term ownership of the stock rather than options trading, exercising makes sense. You convert your option position into a stock position at your predetermined price.
3. Very Deep In-the-Money at Expiration
At expiration, deep ITM options may have very wide bid-ask spreads. The market might not offer fair value. In this case, exercising ensures you capture the full intrinsic value.
4. Illiquid Options
If the option has very low trading volume and wide spreads, you might not be able to sell at a fair price. Exercising could net you more value than selling at a poor price.
Early Exercise Considerations
American-style options can be exercised any time before expiration. However, early exercise usually destroys value because you give up all remaining time value. Early exercise only makes sense in the dividend capture scenario mentioned above.
Rule of thumb: Almost never exercise an option early unless there is a large dividend involved. The remaining time value is almost always worth more than any dividend.
Tax Implications
The choice between exercising and selling can have tax consequences:
Selling Options
- Profit is taxed as short-term or long-term capital gain depending on holding period
- Options held less than one year are taxed at short-term rates
- Options held more than one year are taxed at long-term rates
Exercising Options
- The option cost basis transfers to the stock position
- Holding period for the stock starts from the exercise date
- Capital gains tax is calculated when you eventually sell the shares
Consult a tax professional for your specific situation, as tax laws vary by jurisdiction and individual circumstances.
What About Put Options?
The same principles apply to put options. Selling a put captures both intrinsic and time value, while exercising only captures the intrinsic value. Exercise a put only if:
- You want to sell shares you already own at the strike price
- The option is illiquid and you cannot get a fair selling price
- There is some specific strategic reason (like avoiding short sale restrictions)
Practical Steps for Closing Positions
When you have a profitable option position, follow these steps:
- Check the bid price: This is what you will receive if you sell
- Calculate intrinsic value: This is what you get if you exercise
- Compare: If bid > intrinsic value, sell. If bid < intrinsic value, consider exercising
- Factor in costs: Exercise may involve commission and capital requirements
- Consider your goals: Do you want to own shares or just capture the profit?
Track Your Options Positions
Pro Trader Dashboard helps you monitor all your options positions and see current values. Make informed decisions about when to close your profitable trades.
Summary
In the vast majority of cases, selling your option is better than exercising because you capture both intrinsic and time value. Exercise only makes sense in specific situations: capturing dividends, wanting to own the underlying stock, dealing with illiquid options, or when at expiration with wide bid-ask spreads. Understanding this principle can save you money and help you maximize the value from your options trades.
Learn more about options fundamentals in our guides on buying vs selling options and understanding options moneyness.