Call and put option contracts give you the right to buy and sell the underlying shares at specified prices, known as strike prices, before predetermined expiration dates.
Trading options is very different from trading stocks because options have distinct characteristics from stocks. Investors need to take the time to understand the terminology and concepts involved with options before trading them. Options are financial derivatives, meaning that they derive their value from the underlying security or stock. Options give the buyer the right, but not the obligation, to buy or sell the underlying stock at a pre-determined price. Options have a cost associated with them, called a premium, and an expiration date.
You do not have to exercise these rights if you decide to sell the options. When you exercise a call option, you would buy the underlying shares at the specified strike price before expiration.
Step 1 Compare the strike price of the call option to the current stock price. You would exercise your rights how options appeared buy the shares only if the call option is in the money, meaning the strike price is less than the stock price.
Step 2 Review the company fundamentals, such as earnings growth and consistent cash flow. You should be able to find how options appeared relevant information in quarterly financial statements posted on the company's investor relations website.
If the fundamentals are sound and the outlook is bright, you could exercise your call options and hold on to the shares for long-term capital gains.
Step 3 Compare the profits from selling your call options versus exercising them. Your profits would be 10 cents a contract if you were to close option buyer is also called the call position, which is a 20 percent return on investment.
Step 4 Exercise call options if you are using them to hedge a short sale and the stock price continues to rise. A short sale involves selling shares that you borrow from your broker in the expectation that you can buy them back at lower prices.
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If the stock rallies instead, call options with the appropriate strike price could prevent losses because you could exercise the calls to cover your short position.
Tip The Options Clearing Corporation automatically exercises options if they are in the money by one cent or more.
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Your broker may have different procedures for automatic exercises.