What Happens When a Call Option Hits the Strike Price Before Expiration?

Imagine this: you’ve purchased a call option, and the stock price surges, hitting your strike price. You’re probably excited, but the real question on your mind is: what now? Does hitting the strike price automatically mean profits? Should you immediately exercise the option or wait until expiration? This moment, when your call option strikes, is pivotal and complex, with several nuances to understand in order to maximize your returns.

Before diving into the strategies and outcomes, let's clarify a few terms:

• Call Option: A financial contract giving the buyer the right, but not the obligation, to buy an underlying asset (e.g., a stock) at a predetermined strike price.
• Strike Price: The price at which the holder of the option can purchase the underlying asset.
• Expiration Date: The date by which the holder must decide whether to exercise the option.

So, what happens when the stock price hits your strike price before the option’s expiration? Let’s explore the possibilities in detail.

1. Intrinsic Value Is Now Positive

When the stock price reaches or exceeds the strike price, your call option gains intrinsic value. The intrinsic value is calculated as the difference between the stock price and the strike price. For instance, if the stock is priced at $100 and your strike price is $90, the intrinsic value of your call option is $10 per share. This is the moment when your call option becomes “in the money,” meaning it has real value.

But just because the option is in the money doesn’t mean you should immediately exercise it. There’s more to consider.

2. Early Exercise: Should You Pull the Trigger?

Hitting the strike price before expiration raises a critical question: should you exercise the option early?

Here’s why early exercise is often not the best move:

• Time Value of Money: Options have both intrinsic value and time value. The time value represents the premium paid for the remaining time until expiration. Even though the option has intrinsic value once it hits the strike price, it still retains time value, which can decrease as expiration approaches. Exercising early eliminates this time value, and you could lose out on additional potential profit if the stock price continues to rise.
• Dividends and Interest: The decision to exercise early might hinge on whether the underlying stock pays dividends. In some cases, exercising right before a dividend payout can make sense to collect the dividend, especially if the option is deep in the money.
• Leverage: By holding onto the call option, you maintain leverage. The option allows you to control a large amount of stock with a small initial investment. Exercising early removes this leverage.

Therefore, early exercise is typically reserved for rare situations, such as significant upcoming dividend payments or personal strategic reasons.

3. The Value of Waiting Until Expiration

More often than not, traders prefer to hold their options until the expiration date. Here’s why waiting can be advantageous:

• Maximizing Profits: If the stock price continues to rise, your call option increases in value. The longer you hold the option, the more potential profit you could gain as the stock price rises beyond the strike price.
• Market Volatility: Stocks are notoriously volatile, and the price may fluctuate between now and the expiration date. Waiting allows you to benefit from these fluctuations without committing to an immediate exercise.
• Time Decay: Keep in mind, though, that time decay (also called "theta") accelerates as the expiration date approaches. The closer you get to expiration, the more the time value of your option erodes, potentially reducing your overall profit.

4. Selling the Option Instead of Exercising

Instead of exercising your call option, a more common strategy for retail investors is to sell the option on the open market. Here’s why:

• Profiting from Time Value: Selling the option allows you to realize both the intrinsic and remaining time value, maximizing your return. By exercising, you only capture the intrinsic value, leaving the time value on the table.
• Immediate Liquidity: Selling the option grants you instant liquidity without the need to buy the underlying stock. You lock in your profits and avoid tying up capital.

For example, if you bought the call option at a premium of $2 per share (or $200 for a 100-share contract) with a strike price of $90, and the stock price rises to $100, your option might be worth $12 per share. By selling it, you secure a $10 profit per share ($1,000 profit minus the $200 premium cost).

5. What Happens at Expiration If the Stock Stays Near the Strike Price?

Let’s say the stock price fluctuates around your strike price up until expiration. What happens if the stock closes exactly at your strike price on the expiration date? The answer depends on the specific option contract terms, but generally:

• At-the-Money Options: If the stock price is exactly equal to the strike price at expiration, the option is considered “at the money,” and it will likely expire worthless. In this case, you lose the premium you paid for the option.
• Out-of-the-Money Options: If the stock price falls below the strike price at expiration, the option becomes “out of the money” and expires worthless, with the loss limited to the premium paid.
• In-the-Money Options: If the stock price is above the strike price, your option is in the money, and it will either be automatically exercised (if you hold the option to expiration) or sold before expiration.

6. Psychological Factors: Managing Greed and Fear

When your option hits the strike price, emotions can run high. Greed might push you to hold on for a bigger win, while fear of losing what you’ve gained may prompt you to exercise early. Here’s how you can manage these emotions:

• Set Clear Goals: Have a target price in mind for the stock and stick to it. Whether that’s a certain percentage gain or a specific dollar amount, establishing a clear plan can help mitigate the emotional roller coaster.
• Use Stop-Loss Orders: If you’re holding a large position in the underlying stock after exercising, stop-loss orders can help protect your profits in case of a sudden market downturn.
• Avoid Over-Leveraging: While options provide leverage, it’s important not to over-leverage yourself by purchasing too many contracts, which can lead to substantial losses if the market turns against you.

7. A Real-World Example: The Tesla Surge

Let’s take a look at a real-world scenario involving Tesla (TSLA). In 2020, Tesla’s stock price skyrocketed, catching the attention of investors holding call options. Those who had purchased Tesla call options with a strike price of $600 witnessed the stock price soar to over $2,000 before its stock split. The decision to exercise or sell those call options became a pivotal moment for many traders. While some opted to exercise and hold the stock, others sold their options for huge profits, leveraging the massive intrinsic and time value.

This illustrates the potential upside of holding an option as the stock price moves beyond the strike price. By selling the call option instead of exercising it, many investors were able to capitalize on Tesla’s ongoing price surge without tying up capital in the underlying stock.

Conclusion: When Your Call Option Hits the Strike Price Before Expiration

When a call option hits the strike price before expiration, you’ve entered a critical moment in your trading journey. However, simply reaching the strike price doesn’t mean you should automatically exercise the option. Instead, consider holding onto it, as the time value may still provide significant returns, or sell the option to maximize your profits.

Understanding the intricacies of strike price, time value, and the decision to exercise early can help you navigate these waters more effectively. Remember, options trading involves balancing risk and reward, and being informed about your choices will lead to better outcomes in the long run.