Exercising the Option

Option transactions occur through the exchange on which an option has been listed. While several different exchanges handle options trading, and automated trading has become widespread on the Internet (especially in options), there is but one registered clearing agency for all listed option trades in the United States. The Options Clearing Corporation (OCC) has the broad responsibility for orderly settlement of all option contracts, which takes place through contact between brokerage houses and customers working with the exchange.
Orderly settlement means, generally, that buyer and seller both trade in confidence, knowing that they will be able to execute their orders when they want, and finding a ready market. It also means that all terms of the contract are ironclad; exercise price, expiration date, and availability of shares upon exercise are all a part of the orderly settlement. To ensure orderly settlement and in recognition of the probability that option buying and selling does not always match up, the OCC acts in the capacity of buyer to every seller, and as seller to every buyer.

Smart Investor Tip

Orderly settlement is ensured even when the volume of calls and puts is out of balance; the OCC facilitates the opposite side of every option transaction.

When a customer notifies a broker and places an order for execution of an option trade, the OCC ensures that the terms of the contract will be honored. Under this system, buyer and seller do not need to depend upon the goodwill of one another; the transaction goes through the OCC, which depends upon member brokerage firms to enforce assignment. Remember that buyers and sellers are not matched together one-on-one. A disparate number of open buy and sell options are likely to exist at any given time, so that exercise will be meted out at random to options in the money -- thus the term assignment. Since buyers and sellers are not matched to one another as in other types of transactions, how does a seller know whether a specific option will be exercised? There is no way to know. If your short option is in the money, exercise could occur at any time. It might not happen at all, or it might take place on the last trading day.

When exercise occurs long before expiration date, that exercise is assigned to any of the sellers with open positions in that option. This takes place either on a random basis or on the basis of first-in, first-out (the earliest sellers are the first ones exercised). Upon exercise, 100 shares must be delivered. The concept of delivery is in relation to the movement of 100 shares of stock from the seller of the option to the exercising buyer. The buyer makes payment and receives registration of the shares, and the seller receives payment and relinquishes ownership of the shares.

Smart Investor Tip

The seller often can avoid exercise through a series of steps -- picking out-of-the-money options, taking short-term profits, and exchanging short-term options for longer-term ones. Avoiding exercise makes sense when stock price movement justifies it.

What happens if the seller does not deliver shares as demanded by the terms of the option contract? The OCC facilitates the market and enforces assignment. The buyer is given timely possession of 100 shares of stock, even when the seller is unwilling or unable to comply. The broker will deal with the seller by attaching other assets as necessary, or taking legal action, as well as suspending the seller's trading privileges. The buyer would have no awareness of these events if they occur, because the problem is between the violating seller and the system of broker, exchange, and the OCC. So orderly settlement ensures that everyone trading in options in good faith experiences a smooth, dependable system in which terms of the option contract are honored automatically and without fail.

When a buyer decides to exercise, 100 shares are either purchased from ("called from") or sold to ("put to") the option seller. When you have sold a call, exercise means your 100 shares could be called away and transferred to the buyer; and when you sell a put, exercise means that 100 shares of stock can be "put to" you upon exercise, meaning you are required to buy. The entire process of calling and putting shares of stock upon exercise is broadly referred to as conversion. Stock is assigned at the time of exercise, a necessity because the number of buyers and sellers in a particular option will rarely, if ever, match. The assignment of an option's exercise, by definition, means that 100 shares of stock are called away.

Is exercise always seen as a negative to the seller? At first glance, it would appear that being exercised is undesirable, and it often is seen that way; many sellers take steps to minimize the risk of exercise or to avoid it altogether. However, the question really depends upon the seller's intentions at the time he or she entered the short position. For example, a seller might recognize that being exercised at a specific price is desirable, and will be willing to take exercise with the benefit of also keeping the premium as a profit.

Smart Investor Tip

Some sellers enter into a short position in the hopes that exercise will occur, recognizing that the combination of capital gain on the stock and option premium represents a worthwhile profit.

It is logical that most sellers will close out their short positions or pick options the least likely to be exercised. Sellers have to be aware that exercise is one possible outcome and that it can occur at any time that the option is in the money. The majority of exercise actions are most likely to occur at or near expiration, so the risk of early exercise is minimal, although it can and does occur.

Example

The Early Worm: You sold a call with more than six months until expiration. Confident that exercise would not occur until close to expiration, you were not concerned about the possibility. But in the last few days, the stock's market value rose dramatically. You were taken by surprise when you received notice that your call had been exercised early. The lesson to remember from this applies to all option sellers: exercise can occur any time the option is in the money.

Exercise is not always generated by a buyer's action, either. The Options Clearing Corporation can execute an automatic exercise on options in the money on expiration date. The OCC, acting in the role of buyer on the other side of the short position, would benefit from exercise of in-the-money short options. Automatic exercise occurs because in-the-money short positions are not necessarily exercised by buyers; it is more likely that positions will be closed and profits taken. So outstanding in-the-money short positions are automatically exercised by the OCC to absorb the disparity between the two sides.

The decision to avoid exercise is made based on current market value as well as the time remaining until expiration. Many option sellers spend a great deal of time and effort avoiding exercise and trying to also avoid taking losses in open option positions. A skilled options trader can achieve this by exchanging one option for another, and by timing actions to maximize deteriorating time value while still avoiding exercise. As long as options remain out of the money, there is no practical risk of exercise. But once that option goes in the money, sellers have to decide whether to risk exercise or cancel the position with an offsetting transaction.

Example

Reasonable Assumptions: You bought 100 shares of stock several months ago for $57 per share. You invested $5,700 plus transaction fees. Last month, the stock's market value was $62 per share. At that time, you sold a call with a striking price of 60 ($60 per share). You were paid a premium of 7 ($700). You were willing to assume this short position. Your reasoning: If the call were exercised, your profit would be $1,000 before transaction fees. That would consist of 3 points per share of profit in the stock plus the $700 you were paid for selling the option.
Striking price$60
Less your cost per share-57
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.