Why are so few options ever actually exercised?

Question

What is the reason that only a minor percentage of options get exercised (17%, I read on the OIC website)? If on expiration, the option is in the money, it will be either automatically exercised, or the option owner should exercise it to realize his profit.

What I can think of is (call option scenario):

1. If he does not exercise, his loss=premium paid

2. If he exercises, his profit = spot price - strike price - premium paid - transaction costs.
   If this number > premium paid, he should exercise.

So why are so few options exercised? Is the condition #2 that rare?

Answer 1

There are two reasons why most options aren't exercised. The first is obvious, and the second, less so.

The obvious: An option that's practically worthless doesn't get exercised.

• Options that reach expiry and remain unexercised are almost always worthless bets that simply didn't pay off. This includes calls with strikes above the current underlying price, and puts with strikes below it. A heck of a lot of options.

  If an option with value was somehow left to expire, it was probably a mistake, or else the transaction costs outweighed the value remaining; not quite worthless, but not "worth it" either.

The less obvious: An option with value can be cancelled any time before expiration.

• A trader that buys an option may at some point show a gain sooner than anticipated, or a loss in excess of his tolerance. If a gain, he may want to sell before expiry to realize the gain sooner. Similarly, if a loss, he may want to take the loss sooner. In both cases, his capital is freed up and he can take another position.

  And — this is the key part — the other end matched up with that option sale is often a buyer that had created (written) exactly such an option contract in the first place – the option writer – and who is looking to get out of his position.

  Option writers are the traders responsible, in the first place, for creating options and increasing the "open interest." Anybody with the right kind and level of options trading account can do this.

  A trader that writes an option does so by instructing his broker to "sell to open" a new instance of the option. The trader then has a short position (negative quantity) in that option, and all the while may be subject to the obligations that match the option's exercise rights.

  The only way for the option writer to get out of that short position and its obligations are these:

  1. Not by choice: To get assigned. That is to say: a buyer exercised the option. The writer has to fulfill his obligation by delivering the underlying (if a call) to the option holder, or buying the underlying (if a put) from the option holder.

  2. Not by choice: The option expires worthless. This is the ideal scenario for a writer because 100% of the premium received (less transaction costs) is profit.

  3. By choice: The writer is free to buy back exactly the same kind of option before expiry using a "buy to close" order with their broker. Once the option has been purchased with a "buy to close", it eliminates the short position and obligation. The option is cancelled. The open interest declines.

Options thus cancelled just don't live long enough to either expire or be exercised.

Answer 2

First, in the money options are scarcely created because most options trade at the money with the rest evenly distributed between in and out, so they are at best half the market when created.

They are also closed before expiration.

The reason is still unknown, but one theory is:

Barely in the money options carry enormous exercise risk because the chance that could be turned into a potentially solvency threatening unhedged liability is great; therefore, option sellers prefer to close barely in the money options so not to take on unhedged liability risk.

Statistically, option sellers are risk avoiders.

Answer 3

The original question was a "why does this happen?" question, not "how does it work?" question. The answer to "why does this happen?" is: most options are purchased as part of complex hedging strategies by traders, as risk management, without the expectation that they will be in-the-money at close. They are (mostly) not purchased to make money, but to cap the maximum loss of a complex trade.

Answer 4

There are a number of reasons why only a small percent of options are exercised. For calls:

1) If the call is ITM and still has time premium remaining, exercising it throws away the time premium. Therefore it makes more sense to sell-to-close the option. If coupled with someone who is short the call and is buying to close, the contract ceases to exist and Open Interest declines.

2) It is capital intensive to exercise. Suppose XYZ is $202 near expiration and I own 10 calls ITM worth $2 with a strike price of $200. If I exercise, I need $200k ($100k on margin) to accomplish this. All you need to buy long options is the cost of them. Sell to close the calls and no additional capital is needed.

3) Apropos to the year this question was asked, every trade involves a commission. If you buy and then sell to close the call. it's two transactions. If you buy the call, exercise and then sell the underlying, it's three commissions plus additional bid/ask slippage (unless you trade at one of the few brokers who does not charge a fee for assignment and exercise).

4) On the flip side, consider the writer of the call. Suppose it's a covered call near expiration, the short call is slightly ITM and the investor does not want to lose his stock. Either he buys to close his short call or he rolls it out to a later week/month (still BTC). If coupled with a STC transaction, this too results in a reduction in Open Interest and the contract ceases to exist.

5) Short sellers don't want the expiration risk of a position in the underlying. For example, you sold a $45/50 bearish put vertical spread for $2. You maximum risk is $3 because of the protective long $45 put. On expiration day the stock is $47 and you have a $1 loss. If you do nothing, the $45 put expires, the $50 put will be assigned and on Monday morning you're long the stock with significantly more downside risk. BTC the short put to avoid this risk.

The general theme here is that it's almost always better to close positions than to exercise.