What Happens When an Option Hits the Strike Price Before Expiration?

Options trading can be complex, and a common point of confusion is what happens when an option reaches its strike price before expiration. Many traders assume immediate action is required, but the reality depends on factors like whether the option is a call or put, time remaining until expiration, and market conditions.

Understanding how an option behaves at the strike price helps traders make informed decisions about holding, exercising, or selling their contracts.

In-The-Money Implications

When an option reaches its strike price before expiration, it moves from out-of-the-money to at-the-money and, if the price continues in the same direction, into in-the-money territory. This shift gives the option intrinsic value, which is the difference between the underlying asset’s market price and the strike price. For example, if a call option has a strike price of $50 and the stock rises to $52, the option holds $2 of intrinsic value.

For American-style options, which can be exercised at any time before expiration, traders must decide whether to exercise, sell, or hold their contracts. If a call option is deep in-the-money and the underlying stock is about to pay a dividend, exercising early may be beneficial to capture the payout.

For option sellers, an in-the-money position increases the risk of assignment. A put seller, for example, could be required to buy shares at the strike price if the option holder exercises. This can lead to significant financial exposure, especially if the underlying asset has dropped sharply.

Option Premium Changes

As an option nears its strike price, its premium fluctuates based on implied volatility and time decay. Implied volatility reflects market expectations of future price movement. If volatility rises, the premium may increase even if the underlying asset remains near the strike price. Conversely, a drop in volatility can reduce the premium.

Time decay, or theta, also affects an option’s value. As expiration approaches, the extrinsic value—the portion of the premium beyond intrinsic value—gradually declines. This effect is most pronounced for at-the-money options, where extrinsic value makes up most of the premium. A call option with a $100 strike price may have a total premium of $5 when the stock is trading at $100, consisting entirely of extrinsic value. As time passes, that premium can shrink even if the stock price remains unchanged.

Bid-ask spreads can widen when an option hovers near its strike price, particularly in low-liquidity environments. Market makers adjust pricing based on supply and demand, and uncertainty about the option’s direction can lead to increased spreads, making it more expensive to enter or exit positions.

Potential for Early Exercise

American-style options can be exercised before expiration, but this is typically done for specific reasons rather than simply because the option has reached its strike price.

One factor is interest rates, particularly for deep in-the-money call options. If borrowing costs are high, an investor might prefer to exercise early and take possession of the stock rather than continue holding the option.

Dividend payments also influence early exercise decisions, especially for call options. If a stock is about to pay a dividend, traders holding in-the-money calls may exercise early to become shareholders and collect the payout. This is most common when the dividend exceeds the remaining extrinsic value of the option.

For put options, early exercise is less common but can happen when the option is deep in-the-money with little extrinsic value left. Traders may exercise if they want to sell the underlying asset immediately, particularly if liquidity is a concern or if holding the position offers no further advantage. This is often seen in stocks with borrowing constraints, where short-selling is difficult, and exercising the put allows the trader to sell shares they already own.

Automatic Exercise at Expiration

Options that expire in-the-money are typically subject to automatic exercise, a process managed by the Options Clearing Corporation (OCC) and brokerage firms. The OCC’s threshold for automatic exercise is usually $0.01 in-the-money, meaning any option exceeding this amount will be exercised unless the holder instructs otherwise.

Traders must monitor their positions, as automatic exercise can lead to unintended consequences. If an account lacks sufficient capital to cover the purchase of shares from an exercised call or the obligation to sell shares from a put, brokers may liquidate positions, often at unfavorable prices. Margin requirements also come into play, as an exercised position can significantly alter risk exposure overnight.

Calls vs. Puts

The impact of an option reaching its strike price depends on whether it is a call or a put.

Call options give the holder the right to buy the underlying asset at the strike price. When a call reaches or surpasses this level, its premium typically increases as intrinsic value builds. Traders holding long calls may sell the contract for a profit, exercise to acquire shares, or hold in anticipation of further price appreciation. For call sellers, an in-the-money position increases the likelihood of assignment, requiring them to deliver shares at the agreed-upon price. This can be particularly problematic for uncovered (naked) call sellers, as they may need to buy shares at a higher market price to meet their obligation, leading to potentially unlimited losses.

Put options give the holder the right to sell the underlying asset at the strike price. When a put moves in-the-money, its value rises as the underlying stock declines. Traders may exercise puts to sell shares at a favorable price or close the position for a gain. For put sellers, assignment means they must purchase shares at the strike price, which can be undesirable if the stock has fallen significantly. This risk is especially pronounced in volatile markets, where sharp declines can lead to substantial losses if the assigned shares continue to drop in value.

Assignment Process for Sellers

When an option is exercised, the seller of the contract is assigned the obligation to fulfill its terms, a process handled by the trader’s brokerage and the OCC.

For call sellers, assignment means delivering shares at the strike price. If the seller owns the shares (a covered call), they simply transfer them to the buyer. However, if the call was sold naked, the seller must acquire shares at the current market price, potentially incurring significant losses. This risk is why many traders avoid selling uncovered calls, as losses can be theoretically unlimited if the stock continues to rise.

Put sellers face assignment when the option holder exercises their right to sell shares. This requires the seller to purchase the stock at the strike price, regardless of its current market value. If the stock has dropped sharply, the seller may be forced to buy at a much higher price than the market offers, leading to immediate unrealized losses. To manage this risk, traders often sell puts only on stocks they are willing to own or use spreads to limit downside exposure.