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In this article and accompanying video we will review everything you need to know about how option exercise and assignments work for the SIE & Series 7 Exam We will start off with a vital fact about counterparty risk. Counterparty risk occurs when the seller of the option cannot meet their obligations under the terms of the contract.
What happens If one party to the contract fails?
Option trading would not exist if buyers of options were concerned about the ability to exercise their rights under the contract. If buyers of options were subject to counterparty risk, investors would not be willing to pay the option premium. Let’s look at a real world example.
A person goes down to the local car dealer and purchases a brand new SUV for $58,000. To protect that vehicle, they buy car insurance and pay a premium of $1,500 for the year. Now ask yourself, if this was you and you had any doubt about the insurance company’s ability to pay for your car repair in the case of an accident, would you pay that premium? The answer for most is, certainly not.
Option buyers are no different. The Options Clearing Corporation issues and guarantees option performance. It has eliminated counterparty risk and stands ready to ensure option holders’ rights may be exercised. If one party to the contract fails the OCC will ensure that the holder of the option is made whole
Exercising a call option or a put option on a stock
Exercising a call option or a put option on a stock results in the delivery of the stock regular way or T+1. You can think of the exercise date as the trade date. To calculate the settlement and payment terms, the trade date is considered to be the day the exercise notice was filed. If an investor exercises an ABV June 60 call, on Monday May 15th, the investor will receive 100 shares of ABV on Tuesday May 16th. On the other hand, if an investor exercises a put option, that investor will be required to deliver those shares the next business day.
Exercising an index option or an option that settles in cash
Exercising an index option or an option that settles in cash results in the delivery of cash the following business day. If an investor exercises an S & P 500 6,500 call option when the S& P 500 closes at 6,515, that investor will receive cash equal to the in the money about. To calculate the cash to be credited the S&P 500 uses a $100 multiplier. In this case, the investor would receive 15 X $100 =$1,500.
American-style versus European-style options
An American-style option can be exercised at any time during the life of the option. While a European-style option may only be exercised at expiration. This is a testable point for many of you. Most individual stock options are American-style options and exercisable any time. In our example above, the investor who was long an ABV June 60 call, exercised that option on Monday May 15th. On the other hand, most index options are European options and exercisable only at expiration. The example of the S & P 500 index option being exercised, when the index was at 6,515, could only have taken place on the expiration date. A practical note and an important test point, It is always better to sell American options during their life rather than exercise them. The options’ premium will have both intrinsic value and time value. The time value is the amount by which the premium exceeds the in-the-money amount. If an investor exercises the option prior to expiration, that time value however large or small is lost.
Exercise instructions and OCC assignment
When an investor wishes to exercise their rights under an option they’ll inform their broker-dealer of their exercise instructions and the broker-dealer will send the exercise notice to the OCC. The OCC will take this exercise notice and randomly assign it to a broker-dealer who has a client who has a short option position in that contract.The broker-dealer upon receiving this assignment or exercise notice is required to allocate or assign it to a customer who has an established short position in that series of options.
Allocation methods (fair methods only)
The broker-dealer may use any fair method for allocating the assignment of exercise notices.
They can do it randomly, on a lottery basis, first in/first out or based on the largest short position. A broker dealer cannot assign the notice to the person who can most likely afford the exercise. That’s a test point right there.Keep that in mind.
Expiration timing and automatic exercise
All standard options expire on the third Friday of the month at 11:59 PM ET (10:59 PM CT). All exercise notices must be provided by 5:30 PM Eastern Time (4:30 Central Time) on the day of expiration. The center of the world for options trading is largely Chicago, so 5:30 Eastern is 4:30 Central. This concept may be tested either way. Here is another important point. No options that are in the money by one cent or more will be allowed to expire. This is true for the accounts of both customers and broker dealers. All option holders will have their long options automatically exercised if they are in the money by one cent or more unless the holder has provided negative exercise instructions If an investor is long an XYZ April 75 call and XYZ closes at $75.01, the investor may not want to buy XYZ at $75. In this case the investor must submit negative exercise instructions basically telling the broker dealer “I don’t want this stock.”
This is a great review of the option exercise and assignment information you will be tested on. Good Luck on your SIE & Series 7 exams!
