Options FAQ: Options Exercise

by The Options Industry Council | April 13, 2011 4:56 pm

Options Exercise Questions


Options Exercise Answers

Q: Can I exercise my right to buy the stock at any time up to the expiration date?

A: As the holder of an equity call option, you can exercise your right to buy the stock throughout the life of the option up to the exercise cut-off time on the last trading day before expiration. Options exchanges have a cut-off time of 4:30 pm, Central Time, for receiving an exercise notice. However, most brokerage firms have an earlier cut-off time that should be determined in advance since it may affect when you receive delivery of the stock.

 


Q: What is the difference between American-style exercise and European-style exercise?

A: All standardized equity options use American-style exercise. American-style exercise means that operationally you can exercise your contract any day that the market is open before the expiration date. The last day to exercise an American-style option is usually the third Friday of the month in which the contract expires (expiration Friday). Most index options, however, use European-style exercise. This means that the only time you can operationally exercise your contract is the last trading day (usually Friday) before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration.

 


Q: Are all index options European style exercise?

A: Not all index options are European style, but most index options, it does seem, are European style. For example, the OEX S&P 100 index option is American style. A primary reason that most cash-settled indexes are European style is probably that since there is no actual delivery of the underlying the whole concept of exercise is skewed. (Why exercise an option for cash, when you can sell the option into the market and receive cash?) In addition, early exercise causes serious timing imbalances for combination strategies using cash-settled options.

A second reason might be the mechanics of establishing a settlement price. For an American style index option like the OEX, a settlement price has to be calculated every day and the mechanics of exercise seem to argue for using the closing prices of the component stocks. But back in the 1980′s the industry moved toward using the opening prices of the component stocks for calculating final settlement prices in order to reduce the volatility associated with the ‘triple witching’ phenomenon.

Important to remember: Thursday before Expiration is typically the last trading day for European style index options!

Read more about index option specifications in the Product Specifications section.

 


Q: If I exercise an in-the-money call option, how soon can I sell the stock?

A: As soon as you tell your broker you would like to exercise your right to buy the stock (strictly speaking, given “irrevocable instructions”) you are deemed to be a stock owner. Because of the irrevocable nature of the call exercise, you will be buying the stock at the strike price, and you can sell those shares immediately after giving instructions to exercise.

 


Q: In order to exercise a put or call, do I have to have cash or stock in my account to buy (in the case of a call) or sell (in the case of a put) the shares of stock that underlie the contract?

A: One way to answer your question is to ask yourself, “Which provides the highest price/lowest cost – exercising the rights of the option contract OR selling the contract back into the marketplace?”

If you exercise an option, the settlement will be in three business days, just like if you bought or sold stock on an exchange. So for example if you exercised a call and simultaneously sold the equivalent shares of stock, those transactions would offset each other. Assuming the option is in the money there should be no need to post margin for such a set of offsetting transactions. Of course, you will want to check with your brokerage firm to ensure that you are both on the same page regarding this practice.

 


Q: My option expired 60 cents in-the-money. Would my broker “automatically” exercise that option?

A: Each brokerage firm has a procedure that is spelled out in your account agreement forms. Each customer should become familiar as to what those procedures are. The option holder can always submit instructions to their broker as to whether or not to exercise. There may even be a rare case in which the customer decides that they do not want to exercise an in-the-money option. It is best to have an understanding with your broker as to the actual procedure. They may have a threshold that they impose for automatically exercising customer orders. The Options Clearing Corporation (“OCC”) uses the 1 cent threshold for customer orders, but your firm may have a different threshold. Here is a description of the procedure:

EXERCISE BY EXCEPTION

“Exercise by exception” is an administrative procedure used by The Options Clearing Corporation (“OCC”) to expedite the exercise of expiring options by Clearing Members. In this procedure options which are in-the-money by specified threshold amounts are exercised unless the Clearing Member submits instructions not to exercise these options. “Exercise by exception” is a procedural convenience extended to OCC Clearing Members, which relieves them of the operational burden of entering individual exercise instructions for every option contract to be exercised. It is important to note “exercise by exception”is a procedure between OCC and its Clearing Members and is not intended to obviate the need for customers to communicate exercise instructions to their brokers:

“The exercise thresholds provided for in Rule 805(d) and elsewhere in the rules are part of the administrative procedures established by the Corporation to expedite its processing of exercises of expiring options by Clearing Members, and are not intended to dictate to Clearing Members which positions in customers’ accounts should or must be exercised.” (Rule 805, Interpretation .02)

EXERCISE THRESHOLDS

Expiring options subject to exercise by exception use the following thresholds to trigger exercise:

Equity options: $.01 per contract in-the-money in the customer account; .01 per contract in-the-money in firm and market maker accounts. Index options: $.01 per contract in-the-money in all account types.

Expiring options are determined to be in-the-money or not based on the difference between the exercise price and the “closing price” of the underlying security.

The “exercise by exception” procedure for expiring options described above is sometimes incorrectly referred to as “automatic exercise.” It is important to note “exercise by exception” always allows an OCC Clearing Member to effect a choice not to exercise an option that is in the money by the exercise threshold amount or more, or to exercise an option which has not reached the exercise threshold amount. The exercise threshold amounts used in “exercise by exception” trigger “automatic” exercise only in the absence of contrary instructions from the Clearing Member. Because the right of choice is always involved in “exercise by exception,” exercise under these procedures is not, strictly speaking, “automatic.”

TO MINIMIZE THE POTENTIAL FOR ERROR CUSTOMERS SHOULD COMMUNICATE TO THEIR BROKER OR CLEARING MEMBER EXPLICIT INSTRUCTIONS TO EXERCISE, OR NOT EXERCISE, ANY EXPIRING OPTION CONTRACT.

 


Q: I am confused about exercising my long option position. I believed a stock was going up and bought a 60 strike call for $2.00 when the stock was $59. Then, if the stock does increase in value to $62 and my contract increases in value – to $4.30, I understand I can make a profit by exercising the call. But if I exercise the call, I have to buy 100 shares of the stock at the strike price. What if I only have $2000 in my account and the call is for 60 dollars – will my broker cover me?

A: You may have forgotten that “exercising” and “closing” the option are two alternatives for closing out your option position.

What happens with most options trades (on average, about 60% of the time) is that the option contract is sold to close out their previously purchased contract instead of exercising the contract and taking the stock position.

If you bought the call for $2, and the value of the contract rose to $4.30, you could enter an offsetting order to sell the call option at the “new” higher price and pocket the difference in premiums as a profit, less commissions of course.

 


Q: Is there a comprehensive list on your website of options that expire Friday morning?

A: Yes there is. A link to these product listings can be found at:

http://optionseducation.org/resources/product_specifications/index.jsp

 


Q: I have a covered call (long stock + short call) where the short call option is now in-the-money. When can I expect to be assigned?

A: It depends. An investor needs to look at the premium of a call option in order to determine the likelihood of early assignment. An option’s premium consists of two parts, intrinsic value and time value. Intrinsic value is the amount by which an option is in-the-money. The premium amount in excess of the intrinsic value is time value. When an option is exercised early, any time value that is priced into the option is forfeited. This is one reason that an option might not be exercised early. An option writer should place him/herself in the shoes of the option holder. The option holder’s decision on whether to exercise or sell the option is likely based on the most profitable outcome. The following example illustrates this point: Stock XYZ is currently trading at 32.80. A call option with a strike of 32.50 that expires in two weeks is currently trading at 1.10. The option is in-the-money by 30 cents (32.80 minus 32.50). The time value for the option is 80 cents (1.10 premium minus .30 in-the-money amount). If an investor exercises his/her call and immediately sells the stock, the profit would be 30 cents (before commissions) – the 32.80 stock selling price minus the 32.50 strike price. On the other hand, the investor can simply sell the option at 1.10. By exercising the option, the investor forfeits the option’s time value of 80 cents. In the above example, if the investor wanted to own the underlying stock, the choice to sell the option and use the option proceeds to buy the underlying stock might be the more profitable alternative.

Therefore, there is no definitive way to determine when options will be exercised, as there exist, as illustrated above, reasons why options may not be exercised as soon as they become in-the-money. Finally, OCC randomly assigns exercise notices to brokerage firms, who then assign the exercise notices to their customers. (You should ask your brokerage firm how it allocates assignments.) So chance also plays a role in determining when you are assigned.

 


Q: I have a calendar call spread, and the call I sold is now in-the-money. Will my brokerage firm exercise the long side of my spread to meet delivery obligations if the short call is exercised?

A: If your plan is to meet your stock delivery obligation by exercising your long call, you will need to discuss this with your broker and give your brokerage firm exercise instructions for the long call.

You should also be aware that as the “ex-date” for a dividend approaches, the likelihood of in-the-money calls being exercised increases. Because call holders may seek to “capture” an impending dividend by exercising, a call writer’s chances of being assigned an exercise may increase as the ex-date for a dividend on the underlying security nears.

For more comprehensive information, take our online, interactive Introduction to Spreading class.

 


Q: If I am long an in-the-money call on a stock that goes ex-dividend tomorrow and I instruct my broker to exercise the call before the close today, will I receive the dividend? That is, are the shares credited to my account on the day the exercise is requested, or the next day? Similarly, what happens in the reverse case where I am short a call option and an option holder requests exercise on the day before the underlying goes ex-dividend?

A: As mentioned in Chapter III of the Characteristics and Risks of Standardized Options, “A call holder becomes entitled to the dividend if he exercises the option prior to the ex-dividend date even though assigned writer may not be notified that he was assigned an exercise until after the ex-dividend date. Because call holders may seek to ‘capture’ an impending dividend by exercising, a call writer’s chances of being assigned an exercise may increase as the ex-date for a dividend on the underlying security approaches”.

As noted above, a call holder is entitled to the dividend if the holder exercises the call prior to the ex-dividend date. The flip side is that an assigned call writer (covered or not) would be obligated to deliver the stock PLUS the dividend.

 


Q: How many options expire unexercised? How many are exercised?

A: According to OCC statistics for year 2010 (for activity in customer and firm accounts), the breakdown is as follows:

Closing Sells – 71.6%
Exercised – 7.9%
Unexercised at Expiration – 20.5%

So, in 2010, 20.5% of all options positions in customer and firm accounts expired unexercised; 7.9% of these positions were
exercised; and 71.6% of these positions were closed out through sales.

 


Q: I bought an index put option and just now have learned that it has a “European” exercise style. Does this mean I can not close my position until expiration?

A: The exercise style of an option does not prevent an investor from closing the position by engaging in a closing transaction on an exchange up to and including the last trading day for the contract. A long (purchased) option contract can be closed by one of two methods: entering into a closing sale at an options exchange, or by exercising the contract. A European exercise style option can only be exercised at expiration so the only way to close your position prior to expiration is to execute a closing trade.

Index options can have different exercise styles and trading hours. Option holders will want to make certain they know the difference between closing an open option position by exercising the contract, and closing the position via a trade on an exchange. Even the last trading day for expiring options can vary. The contract specifications of these index products contain important trading information regarding these options. To review index contract specification, visit http://optionseducation.org/resources/product_specifications/index.jsp.

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