How to Exercise a Call Option and What Happens Next

A call option is a financial contract granting the holder the right, but not the obligation, to purchase an underlying asset at a predetermined price, known as the strike price, before a specific expiration date. This contract allows an investor to benefit from an increase in the asset’s price without immediately owning the asset itself. This article outlines key considerations, procedural steps, and subsequent outcomes for exercising a call option.

Key Considerations Before Exercising

Before deciding to exercise a call option, investors must understand the contract’s fundamental characteristics. The option’s type, either American or European, dictates when it can be exercised; American options offer flexibility, allowing exercise at any time up to and including the expiration date, while European options can only be exercised on the expiration date itself.

A call option is considered for exercise when it is “in-the-money,” meaning the underlying asset’s current market price is above the option’s strike price. For example, if a stock trades at $60 and you hold a call option with a $50 strike price, the option is in-the-money by $10. Exercising an out-of-the-money or at-the-money call option, where the market price is at or below the strike price, is not financially beneficial as it would mean buying the shares at a price equal to or higher than the current market value.

Investors exercise a call option to acquire ownership of the underlying shares, either for long-term investment purposes or to sell them immediately for a profit. Another reason could be to capture an upcoming dividend payment from the underlying stock. Exercising might also be considered to avoid the potential loss of premium for a deep in-the-money option nearing expiration.

Selling the call option in the open market is often a more common and profitable choice than exercising. When an option is sold, the investor realizes its intrinsic value plus any remaining time value. Exercising an option means giving up this time value, which can be substantial, especially for options with a long time until expiration. Selling the option allows an investor to profit from the option’s premium without needing to acquire the underlying shares or commit additional capital.

Executing the Exercise

The process begins by contacting your brokerage firm. Most brokerage platforms offer several methods for initiating an exercise request, including online platforms or a phone call. Brokerage firms typically have cutoff times for receiving exercise instructions to meet exchange deadlines, which are often earlier than the exchange’s official cutoff.

The investor must clearly specify the exact option contract for exercise, including the underlying asset, the strike price, the expiration date, and the number of contracts. Each standard equity option contract represents 100 shares of the underlying stock. The broker will then process the request, which involves submitting an exercise notice to the Options Clearing Corporation (OCC).

Exercising a call option results in the acquisition of the underlying shares, which is known as physical delivery. To complete this, the investor must have sufficient funds in their brokerage account to cover the cost of purchasing the shares at the strike price. This cost is calculated by multiplying the strike price by the number of shares per contract (e.g., $50 strike price x 100 shares x 1 contract = $5,000). Some options, particularly index options, are cash-settled, meaning the investor receives a cash payment equal to the difference between the underlying index’s value and the option’s strike price, rather than acquiring physical shares.

Following the exercise, there is a standard settlement period for the transaction to finalize. For most equity options, this settlement period is two business days (T+2), meaning the shares are delivered to the investor’s account and the corresponding funds are debited two business days after the exercise date. Investors should also be aware that some brokerage firms may charge a small exercise fee for processing the transaction.

Post-Exercise Outcomes

Upon successful exercise and settlement, the investor owns the underlying shares. The cost basis for these newly acquired shares is determined by adding the strike price paid for the shares, the premium originally paid for the call option, and any exercise fees charged by the broker. For instance, if an option with a $20 strike price was bought for a $1 premium and exercised, the cost basis for the acquired shares would be $21 per share, plus any fees.

The acquisition of shares through option exercise has tax implications that investors should understand. No direct tax is due at the moment of exercise; instead, the tax event occurs when the acquired shares are subsequently sold. When these shares are sold, any profit or loss realized will be treated as a capital gain or loss. The holding period for determining whether the capital gain or loss is short-term or long-term begins on the date the shares are acquired through exercise, not the date the option was originally purchased.

Short-term capital gains, from shares held for one year or less, are taxed at ordinary income tax rates, which are higher than long-term capital gains rates. Long-term capital gains, from shares held for more than one year, may receive more favorable tax treatment.