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AN American type of option is one where the option contract can be exercised at any time between the date of purchase and the expiration date.

When you exercise an option, the result may be different depending on the type of settlement. In the case of cash settlement, as existing in India, the difference between the market price and strike price will be paid to the option buyer while in the case of delivery-based settlement, as present in the US, the buyer will pay the strike price and take delivery of the underlying share.

What happens in the case of interim exercise of options on individual securities in our country? According to NSE, interim exercise settlement for Option contracts on Individual Securities is effected for valid exercised-option positions at in-the-money strike prices, at the close of the trading hours, on the day of exercise. Valid exercised-option contracts are assigned to short positions in option contracts with the same series, on a random basis. The interim exercise settlement value is the difference between the strike price and the settlement price of the relevant option contract. Exercise settlement value is debited/ credited on T+3 day (T= exercise date).

The investor may be long in call or put option. The question is, in the case of call option, whether you should exercise your option if it is in-the-money? It is never optimal to exercise an American type call option on a non-dividend paying stock before the expiry date. Why is it so?

Consider a call option on Infosys with a strike price of 3000 and expiring on 26th September. The stock is currently trading at Rs 3,450 and the company is not planning to make any dividend payments in the next one month. Since the strike price is fairly deep in the money, the investor who owns the option may be tempted to exercise the option immediately.

Since options are cash settled in the Indian context, only the difference between the current price and the strike price will be paid.

If the exercise is settled through delivery, as in the US, then if the investor plans to hold the stock for more than a month, this is not a good strategy.

A better alternative will be to keep the option live and exercise it at the end of the month. This is because, if it is exercised now, the amount of 3000 per share is payable immediately. By delaying the purchase by a month, the option holder can earn interest on this amount for this period. Since the stock is not paying any dividend, the investor is also not sacrificing any dividend, which he would have got due to early exercise. A further advantage is that there is a possibility that the stock price may go below 3000 in the next one month. In such an eventuality, the option will expire worthless and the investor will be glad that he had not exercised early.

Alternatively, the investor may think that the stock is overpriced at the current level and the chance of further capital appreciation is limited and hence wants to cash in on the rise in price. In this case, the investor is better off selling the option than exercising it. If you sell the call to close, you will collect the intrinsic value plus the time value. You are always better off selling the call to close if you do not want to continue holding the call option. When you sell, the option will be bought by another investor who has a different perception on the price behaviour of the stock.

If the option series is not liquid enough for you to sell in the market, then you can keep the option open but short the stock in the futures market. This will lock in the profit at the current market price (or slightly higher also since futures price are normally higher than the spot rate due to cost of carry).

One reason why a call option should not be exercised early is due to the insurance it provides. As a buyer of a call option, you have the right to buy the stock at the strike price and not an obligation. By holding onto the option till expiry, it provides an insurance against the stock declining below the strike price. Once the option is exercised and the strike price has been exchanged for the stock (in case it is settled through delivery), the insurance vanishes.

Another reason is the time value of money. The later the amount is paid, the better it is for the investor since the amount paid is the same whether it is paid now or later. Finally, in the case of cash settled transactions, it is always better to earn a higher price by selling to close and earn the time value in addition to intrinsic value.

If you have any queries relating to the futures/options markets and strategies that can be used in these markets, please mail them to Futures& Options, Kasturi & Sons, 859-860, Anna Salai, Chennai 600 002 or email them to vaidy@thehindu.co.in with a mention of futures/options in the subject line of the mail.

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