The Basics
If you are going to trade options it is mandatory to have some basic idea of how the process works. That does not mean that you should pan to exercise options that you own. When you no longer want to own the option, it is almost always better to sell the option, rather than exercise. 

The owner of a call option has the right to buy 100 shares of the underlying asset (stock or ETF) by paying the strike price per share.

That right evaporates when the option expires shortly after the close of business on the date specified in the option contract..

The owner of a put option has the right to sell 100 shares of the underlying asset (stock or ETF) and receive the strike price per share. That right evaporates once the option expires.

 

Exercise
When the option owner elects to do what the contract allows, the terminology used is that the owner "exercises his/her rights." Thus, 

• When a call owner exercises rights, he/she buys 100 shares at the strike price.
• When a put owner exercises rights, he/she sells 100 shares at the strike price.

 

The Process
The call owner notifies the broker of a desire to exercise an option. Once that notice is given, it cannot be revoked. In other words, it's a done deal. The cutoff time for exercising an option is shortly after the market closes for trading each business day. However, it is possible that your broker requires an earlier notification (perhaps five minutes earlier). The best practice is for you to ask your broker's customer service department to tell you the cutoff time and how they want to be notified. Most likely it will be via the Internet, but they may accept a telephone call. It is your responsibility to understand the process. If your broker is not notified of your intention, then the option will not be exercised.

When the broker is notified, it will notify the OCC (Options Clearing Corporation).

The OCC takes care of the process and there is nothing for you to do. The "trade" occurs overnight and when you look at your positions in the morning, you will see some changes.

If you exercised a call option, you now own 100 shares

• The cash to pay for those shares has been removed from your account (stock purchases settle in three business days, so the cash may not be removed for another two business days).
• The option has been "used" and no longer exists. Thus, you will not see the option in your account.
• For tax purposes, you bought the stock yesterday (the date of exercise); the price of purchase is the sum of two items: The strike price PLUS the cost (premium) of the option.

 

If you exercised a put option, you sold 100 shares

• If you owned those shares, they were sold and are not in your account.
• If you did not own the shares, then they were sold short and a short position appears in your account.
• The cash for selling the shares will be in your account in two business days.
• The put option has been used and no longer exists
• For tax purposes, you sold stock yesterday. The sale price equals the strike price MINUS the option cost (premium).

 

Something you may not expect
Once you buy or sell an option, you are disconnected from the person with whom you made the trade. You never have to be concerned with whether the other party can honor the contract -- if and when you elect to exercise. The OCC guarantees the validity of all option contracts and they take over the exercise process.

You may want to know: When you exercise a call option, who sells the stock? After all, the stock is supposedly above the strike price, so who would sell it at the strike price. Answer: You buy stock from another person who sold the specific option that you are exercising. See the article on Assignment for the details.