When should a Put Option be exercised?

What is a Put Option?

A put option is a contract that allows the option holder to sell a number of underlying securities at an agreed-upon price before a certain date. The price at which put option’s securities are sold is known as the "strike price."

When the option is exercised, the writer or issuer of the option is obligated to buy the option at the strike price. Exercising means the owner of the option is using their right to sell the option to earn a profit from it according to the given norms while the option was formed.

Note − The writer of a put option is often a bank or other financial intermediary that is obligated to buy the put option when it is exercised. The rules of buying and selling are however determined prior to the sale of the option by the writer to the option holder.

How does a put option work?

Put options should be exercised when they are in the money, meaning that the strike price is higher than the value of the underlying asset. If the price of the underlying is less than the strike price, the option owner can sell the option to earn a profit from it. However, if the option is at the money or out of the money, there is no use in exercising it as no intrinsic value can be derived from the exercise.

Selling the option

An alternative to exercising the option is to sell it back in the market. Selling is the easiest and most popular way of closing a put option as it does not need any time or involves no cost for short-selling. In selling, there is no exchange of shares, only the investors get a net gain or loss from it due to the current market price of the underlying asset.

Note − The only best time to exercise a put option is when the option is in the money. In all other cases, it is unprofitable to sell the option, and hence selling the option in the market is the best option in case of put options. 

Benefits of Selling

There are many benefits of selling put options instead of exercising them. The asset prices underlying an option keep changing frequently over time and they may be deep in the money or far out of the money. Trading in such situations can be tiresome and risks may go up extensively in such cases. This makes the put option selling far more enriching than exercising them.

The brokerage charged for exercising may be big enough to deter one away from exercising the puts. Many brokers charge huge amounts of commission for exercising the put options which leaves the owners barepocketed after an exercise. Selling the put option in such circumstances may be more rewarding and profitable.

Probir Banerjee

Published on 04-Oct-2021 11:26:03

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