Stock options give you the right to buy shares at a specific price. You can hold a market-traded option in your brokerage account or have options from your employer to buy the company's stock. All market-traded options, and often employee options, have expiration dates by which you need to make a decision whether or not to exercise your rights. The deciding factor comes down to the "moneyness" of your options.
TL;DR (Too Long; Didn't Read)
If you don't exercise an out-of-the-money stock option before expiration, it has no value. If it's an in-the-money stock option, it's automatically exercised at expiration.
Understanding Option Functions
A stock option gives you the right to purchase shares at a preset price. In market terminology, the price at which you can exercise an option is called the strike price. So if you hold an option with a $25 strike price, if you exercise the option, you will pay $25 per share.
It does not matter where the actual market price of the shares currently sits. You can see that an option will get more valuable as the underlying stock price increases.
In the Money
The relationship between the exercise or strike price of your options and the current market price of the stock determines much of the value of the options. If the stock price is above the option strike price, the option is "in-the-money." Exercising the option will let you buy shares for less than what you can sell them for on the stock exchange.
If the stock is below the strike price, the option is "out-of-the-money." In this case, there is no financial reason to exercise the option because you can buy the shares cheaper on the open market.
Approaching the Expiration Date
If an option is out-of-the-money on the expiration date, the option has no value and basically expires worthless and ceases to exist. When an option is in-the-money and expiration is approaching, you can make one of several different moves. For marketable options, the in-the-money value will be reflected in the option's market price. You can either sell the option to lock in the value or exercise the option to buy the shares.
If you hold in-the-money options until expiration, your broker will automatically exercise them for you, and you will own the stock shares Monday morning – market options always expire on a Friday. For employee stock options, you need to make sure you exercise in-the-money options before they expire. Typically, the broker that handles employee stock options will allow you to get cash for the in-the-money value or the shares.
Calls Versus Puts
Employee stock options and market-traded call options give you the right to buy stocks at the strike price. The options markets also offer put options, which give you the right to sell shares at a preset price. A put option will be in-the-money if the stock is below the strike price and will be automatically exercised by your broker if the option is allowed to reach expiration. If the stock price is above the put option strike price, the option will expire without value.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.