Closing vs. Exercising Options: What's the difference?

If you're new to options trading, you might be wondering whether to close your position or exercise your option.

Which choice would be more profitable, and what are the key differences?

Many courses calculate profits based on exercising the option, which can create the impression that exercising is necessary after buying.

but in practice, you have other options.

In the U.S. stock markets, most investors actually prefer to close their positions before the options expire rather than exercising them early or waiting until expiration.

Why? Because in many cases, closing a position may help you earn more money.

Reason 1: Early exercising means giving up the time value since an in-the-money option's value includes intrinsic value and time value, which usually results in lower returns than those obtained through closing the position.

Reason 2: Additionally, whether you exercise early or at expiration, you'll need to have enough stocks or cash on hand. This means a substantial amount of capital is required, which typically results in a lower yield compared to closing out the position.

That said, exercising isn't always a bad choice. In certain situations, it can be an appropriate decision.

Learn more: When is it appropriate to exercise an option?

Next, let's explore the differences between closing and exercising your options.

By understanding these distinctions, you can choose an appropriate trading strategy based on your specific circumstances.

I. Closing vs. exercising for options buyers (long position)

We know that after an options buyer opens a position by purchasing an option, there are two basic ways to manage the trade: closing the position or exercising it.

Closing and exercising are two distinct concepts with significant differences!

1) Closing the position  

You are an options buyer (you already hold a long position in options), and there are other options buyers in the market.

When other options buyers also want to purchase options (which means they have cash on hand), you can resell your option to another options buyer, hoping to profit from the price difference between the option contracts.

For example, yesterday, you bought 1 NVIDIA Call option (strike price $110, premium $8, contract multiplier 100), spending a total of $800 in premium.

Today, NVIDIA's stock price has risen to $120, and the option premium has increased to $15.

At this point, you can choose to sell the option to close your position, receiving $1,500. Therefore, your potential profit would be $1,500 - $800 = $700.

(Note: American style options can be closed on any day before or on the expiration date. Most stock options traded are American style options.)

2) Exercising the Option  

This means exercising the right to buy or sell the underlying stock according to the option contract, with the expectation of profiting from the difference between the stock price and the strike price.

In this case, the trading parties are the options buyer (the holder of the long position) and the options seller (the holder of the short position).

(Note: American style options can be exercised on any day before or on the expiration date; they can be exercised early, at expiration, or not exercised at all.)

For a Call option, exercising it will result in obtaining the underlying stock.

For example, yesterday, you bought 1 NVIDIA Call option (strike price $110, premium $8, contract multiplier 100), spending a total of $800 in premiums.

Today, NVIDIA's stock price has risen to $120, and the option premium has increased to $15.

If you choose to exercise, you can buy 100 shares of NVIDIA stock from the option seller for $110. Therefore, your gain would be (120 - 110) * 100 * 1 - 800 = $200.

（Note: This is a paper gain. no potential profit is realized until the investor closes their position in the underlying stock. Until then the price of the underlying can go up or down affecting your potential profit or loss.）

For a Put option, exercising it will result in receiving cash.

For example, yesterday, you bought 1 NVIDIA Put option (strike price $110, premium $4, contract multiplier 100), spending a total of $400 in premiums.

Today, NVIDIA's stock price has dropped to $100.

If you choose to exercise, you can sell 100 shares of NVIDIA stock to the option seller at $110.

Since the current market price is $100 and your selling price is $110, your gain would be (110 - 100) * 100 * 1 - 400 = $600.

（Note: Again, any potential profit would only be a paper gain as in this scenario you would be assuming a short position in the underlying stock. No profit or loss is realized until the investor 'buys to close' their stock position.）

II. Closing vs. exercising for options sellers (Short Position)

For options sellers, after selling an option to open a position, they have two main choices: actively closing the position or waiting for the buyer to exercise the option.

This is similar to the situation for options buyers but with some differences in details.

1) Closing the position  

If the options seller believes that future market trends may lead to increased losses, they can choose to actively close their position to cut potential losses by buying the same option (with the same underlying asset, strike price, and expiration date), thereby closing their short position.

The trading parties are: the options seller (the holder of the short position, who now wants to buy to close) versus another options seller (the counterparty).

(Note: In the U.S. stock markets, options sellers typically actively close their positions when they want to stop loss and close out their short positions.)

2) Waiting for the buyer to exercise  

If the options seller does not close the option contract, the agreed terms still apply.

Whether the options seller needs to fulfill the obligation depends on whether the options buyer exercises the option.

If the options buyer chooses to exercise the option, and the exercise order is assigned to that seller, they must fulfill the obligation to buy/sell the stocks at the agreed strike price.

Of course, if the options buyer decides not to exercise, the seller will profit from the entire premium and will not have to fulfill any obligations, happily keeping the earnings.

The trading parties are the options seller (the holder of the short position) vs. the options buyer (the holder of the long position).

(Note: Option buyers have the freedom to exercise early and options that are out of the money, so as an option seller, you should always ensure that there are sufficient cash or margin in your account to handle unexpected exercises.)

Learn more: How can options sellers manage risk?