How to Exit an Options or Warrants Trade

When options and warrants are used to trade their underlying market (e.g. a stock index or an individual stock) the trade can be exited in one of two ways. Both ways are equally correct, but one of the ways incurs less commission, and has the potential to be slightly more profitable.

Exercising Options and Warrants

Exercising options and warrants is one of the methods that can be used to exit an underlying trade. When options and warrants are exercised, their right (buying or selling) is executed, and they are exchanged for the appropriate position in their underlying instrument. For example, exercising a call stock option or warrant, would buy the underlying stock at the strike price, potentially entering a long stock trade (assuming that there was no already existing short stock trade).

A long stock trade that was made using options or warrants, and was exited by exercising the options or warrants, would be entered and exited as follows:

1. Enter the trade by buying call options or warrants
2. Wait for the price of the underlying stock to move up
3. Exercise the call options or warrants, thereby buying the underlying stock at the strike price
4. Exit the trade by selling the underlying stock at the current market price, keeping the difference between the strike price and the current market price in profit

Selling Options and Warrants

Selling options and warrants is the other method that can be used to exit an underlying trade. When options and warrants are sold, the underlying trade is exited immediately, without executing any of the options' or warrants' rights, nor involving the underlying instrument.

A long stock trade that was made using options or warrants, and was exited by selling the options or warrants, would be entered and exited as follows:

1. Enter the trade by buying call options or warrants
2. Wait for the price of the underlying stock to move up
3. Exit the trade by selling the call options or warrants, keeping the difference between the buying and selling prices in profit

Selling Options and Warrants Is Preferred

Even though both methods (exercising and selling) result is the underlying trade being exited, there are a couple of differences that make selling options and warrants the preferred method of exiting:

Commission

When options and warrants are exercised to exit an underlying trade, the underlying stock is both bought and sold, and this incurs additional commission (which could be quite substantial for significant numbers of shares). When options and warrants are sold to exit an underlying trade, the underlying stock is not involved, so there is no additional commission.

Time Value

The value of options and warrants consists of both intrinsic value (if they are in the money) and time value. The intrinsic value is the bulk of the profit that will be received when the underlying trade is exited, but the time value can be quite substantial if there is a significant amount of time remaining before the options and warrants expire.

When options and warrants are exercised to exit an underlying trade, the intrinsic value is received in profit, but the time value is lost. When options and warrants are sold to exit an underlying trade, both the intrinsic value and the time value are received in profit.

Trading Example

The following is an example of a short trade on an individual stock (XYZ) that is made using call options or warrants. The parameters of the trade are as follows:

• Symbol: XYZ
• Stock Price: $29
• Put Option Price: $1.80
• Put Option Strike Price: $30
• Put Option Expiration: April 2009

The underlying trade would be made as follows:

1. Enter The Trade - Enter the trade by buying 10 put options at a total price of $1,800 ($1.80 x 100 x 10 = $1,800).
2. Wait For The Stock Price - Wait for the underlying stock price to move down to $25, which increases the intrinsic value and therefore the price of the put options to $5,100 ($5.10 x 100 x 10 = $5,100).
3. Exit The Trade (Exercising) - Exit the trade by exercising the call options (thereby selling 1,000 shares of the underlying stock at the strike price of $30), and buy the underlying stock at the new stock price of $25. The difference between the strike price and the new stock price, minus the initial cost of the put options, is $3,200, and is kept in profit ($30,000 - $25,000 - $1,800 = $3,200).
   Or
4. Exit The Trade (Selling) - Exit the trade by selling the put options at their new price of $5.10. The difference between the selling price of the options and the initial cost of the options is $3,300, and is kept in profit ($5,100 - $1,800 = $3,300).

As shown by the example trade (which is made up, but uses approximately correct prices from a real stock and its options), there is an additional profit of $100 when the underlying trade is exited by selling the options or warrants instead of exercising them. Therefore, selling options and warrants is the preferable and more profitable way of exiting an underlying stock index or individual stock trade, and is always the method that is used by professional traders.