Option Exercise and Assignment

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1 1-888-OPTIONS YOUR DESTINATION FOR OPTIONS EDUCATION SUMMER 08 Option Exercise and Assignment By: Peter Lusk In this summer 2008 issue: Feature: Option Exercise and Assignment Your options questions answered: Bid and Ask Readers quotes Common options terms Fall seminar schedule New Volatility Semianr! G iven the steady increase in options trading volume and many new market participants, this is a good time to review the important aspects of an option s exercise and assignment. With a complete understanding of exercise and assignment ramifications you will have greater knowledge to make successful decisions in your options trading. Assignment and Options There are two kinds of option contracts call options and put options. A call option gives the buyer the right to purchase stock at a specified price until expiration. For this right, the call buyer pays a premium for the option. If the call owner (holder) exercises this right, then a seller of the same option is assigned the exercise, and therefore is obligated to sell the stock at the specified price. In return for assuming this obligation, the call seller receives a payment for the option. A put option gives the buyer the right to sell a stock at a specified price until expiration. For this right the put buyer pays a premium for the option. The seller of a put option is obligated to buy the stock at the specified price until expiration should assignment occur. In return for assuming this obligation, the put seller receives a payment for the option. A buyer s rights are intact from the time he purchases the option until it expires or he sells continued inside

2 PAGE 2 Options on stocks and ETFs can be exercised or assigned at any time during the life of the contract. Option sellers are obligated to sell or purchase the underlying security when called upon to do so. Assignment will usually occur when an option has little or no time left until expiration and is in-themoney (ITM). With a dividend paying stock, assignment will usually happen just before or after an ex-dividend date for calls and puts, respeccontinued from front Peter B. Lusk is an instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange. He teaches option courses for public and institutional traders and has contributed educational type articles to various financial publications. Prior to working at the Options Institute, Peter was a highly successful market maker for 10 years on the floor of the CBOE trading equity options. He was also involved in options training for new market makers at Lakota Trading in Chicago. As a professional trader, Peter enjoys sharing his knowledge of proven option strategies and risk management. In addition to his responsibilities at the Options Institute, Peter serves as an OIC Instructor. the option. An option seller is obligated to take the opposite position of the buyer if and when the option is exercised. A seller may buy the option back to close the position at any time. The Options Clearing Corporation (OCC) was founded in conjunction with the introduction of listed options trading in OCC clears and guarantees settlement of all option transactions for stocks, stock indexes and Exchange Traded Funds (ETFs) listed on all U.S. options exchanges. Exercising and Options There are two exercise types for option contracts American style and European style. American style options can be exercised at any time between the date of purchase and the expiration date. All options on stocks and ETFs traded on the U.S. options exchanges are American style. European style options can only be exercised at expiration. Therefore, there can be no early assignment with this type of option. For example, some index options Assignment will usually occur when an option has little or no time left until expiration and is in-the-money (ITM). including SPX SM and OEX are European style. To obtain a complete list of European style contracts, visit OIC s Web site at or refer to your brokerage firm. Welcome to the summer 2008 issue of Options Central The Options Industry Council s educational newsletter! FROM THE Editor In this issue, Peter Lusk, an OIC exchange instructor, talks about the foundations behind exercise and assignment for options trading. Then in the Bid and Ask section, OIC s Help Desk answers questions regarding the automatic exercise threshold, and gives an updated explanation about the delay to the Jan LEAPS cycle. Don t forget to review our Readers Quotes section where fellow investors share their thoughts. We hope you enjoy reading this issue of Options Central and as always, we welcome your feedback!

3 PAGE 3 An investor needs to understand the impact of dividends and interest rates when making decisions to exercise an option. tively. We will define the dividend effect on options later on in this article. Most online brokerage firms will automatically exercise an option that is $.01 or more ITM at expiration. Investors need to be very aware of the ramifications of automatic exercise. As you may know, there are many influences that can affect a stock price earnings, product announcements and world events, just to name a few. An option s automatic exercise at expiration can put you at risk for a gap opening on the underlying the Monday following expiration. You don t want to be automatically placed into a position of risk if that was not your initial intent. Many investors close their option positions as expiration nears for this very reason. Purchasing an option gives you the right to exercise your option but you are not obligated to do so. You have the ability to decline your exercise right and not engage in a short or long stock position for whatever reason. It is strongly advised that all investors become familiar with their brokerage firm s practices regarding exercise and assignment. OCC has an exercise cutoff time. Brokerage firms have an earlier time when they would like to be informed of an exercise notification. Brokerage firms need this extra bit of time to notify OCC of any option exercises. Be aware of your brokerage firm s cut-off times regarding option exercise or do not exercise notifications. If the owner of an equity call option invokes his right to exercise, he will have a long stock position. The owner of an equity put option can exercise the put to create a short stock position. All options on stocks and ETFs are settled in stock. For cash-settled index options, the cash settlement would be the difference between the strike price and the closing value of the underlying index. Index options including SPX and XAU are settled in cash. There are option traders and option investors. Option traders look to profit quickly by buying and selling options, paying close attention to volatility and small changes in the underlying. Option traders have little interest in exercising options to create long or short stock positions. Option investors use options as a low-cost alternative with reduced risk to own the stock, or as insurance to protect their portfolios against risk. It is the option investor who has many considerations prior to exercising his option contracts. Things to Keep in Mind An investor needs to understand the impact of dividends and interest rates when making decisions to exercise an option. With a dividend paying stock, you must understand that after the ex-dividend date, the stock price is reduced by the dividend amount. Hence, as the stock price is adjusted lower, the value of the ITM call option also decreases. By exercising the ITM call prior to the exdividend date, you can assure yourself the dividend income. It makes absolutely no sense to exercise a call prior to expiration when there is no dividend because of the cost to hold the long stock position. You must consider the cost to carry a long stock posi-

4 PAGE 4 tion in relation to the remaining time until the option expires. When there is a dividend, the only time it would make sense to exercise a call would be just prior to the ex-dividend date before expiration. It is strongly advisable to exercise a deep ITM put prior to expiration. The short stock created by exercising the put will allow you to earn interest income on the cash received from the sale and delivery of stock. Many investors exercise the put the day after the ex-dividend date because the ITM put will have added value after the stock price is reduced by the amount of the dividend. Here s an example: XYZ corporation stock closed today at $ Shareholders of XYZ that own the stock before XYZ begins trading tomorrow morning will be entitled to a $0.25 dividend per share. If XYZ opens unchanged, it will be trading at $ A shareholder will have shares at $53.75 and a $0.25 dividend. Interest rates have an impact on whether or not to exercise a put option early. If the cash value from the sale of the stock is substantial enough, an early exercise would be advisable. It s to your benefit to take advantage of the interest income from the sale of the stock. Hopefully, you now have a good understanding about the mechanics of exercise and assignment. Be sure to become familiar with the rules of your brokerage firm. Until next time, best wishes in all of your trading endeavors! Common Options Terms Assignment Notification by The Options Clearing Corporation (OCC) to a clearing member that an owner of an option has exercised his or her rights thereunder. For equity and index options, assignments are made on a random basis by OCC. Exchange-Traded Funds (ETFs) ETFs are index funds or trusts that are listed on an exchange and can be traded in a similar fashion as a single equity. Investors can buy or sell shares in the collective performance of an entire stock portfolio or a bond portfolio as a single security. ETFs allow some of the more favorable features of stock trading, such as liquidity and ease of equity style features to more traditional index investing. Ex-Dividend Date The day before which an investor must have purchased the stock in order to receive the dividend. On the ex-dividend date, the previous day's closing price is reduced by the amount of the dividend (rounded up to the nearest eighth) because purchasers of the stock on the ex-dividend date will not receive the dividend payment. This date is sometimes referred to simply as the 'ex-date,' and can apply to other situations. Exercise To invoke the rights granted to the owner of an option contract. In the case of a call, the option owner buys the underlying stock. In the case of a put, the option owner sells the underlying stock. In-the-Money (ITM) An adjective used to describe an option with intrinsic value. A call option is in-the-money if the stock price is above the strike price. A put option is in-the-money if the stock price is below the strike price. Out-of-the-Money (OTM) An adjective used to describe an option that has no intrinsic value, i.e., all of its value consists of time value. A call option is out-of-the-money if the stock price is below the strike price. A put option is out-of-the-money if the stock price is above the strike price. To simplify the computations, the examples in this article do not include commissions or transaction costs. Commissions and transaction costs will affect the outcome of all stock and options transactions and must be considered prior to entering into any transaction. Investors considering options should consult their tax advisors as to how taxes may affect the outcome of contemplated options transactions. Premium The total price of an option: intrinsic value plus time value. Often (erroneously) this word is used to mean the same as time value.

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5 PAGE 5 Save the Date! Hyatt Regency Chicago November 10, :00 a.m. - 5:00 p.m. (Registration Opens at 8:00 a.m.) Session Topics: Options Fundamentals Options on ETFs Real-Time Trading Option Greeks and Volatility Ideas Into Action Visit for registration information! Want to boost your Options IQ? Buy OIC s An Investor s Guide to Trading Options TODAY at 40%off! The Guide uses straightforward language combined with creative illustrations, making this an inviting, yet comprehensive look into the world of options. Learn what options are, how they work, real-world investing scenarios, and strategies for various market conditions. For more information or to order, call OPTIONS or visit 40% off Sale! Bulk order discounts and customization opportunities are available.

6 PAGE 6 Bid AND Ask Readers Quotes Q: Has there been a recent change to the Exercise-by- Exception (Ex-by-Ex) automatic threshold? A: At the request of its clearing members, The Options Clearing Corporation (OCC) received approval to reduce the threshold for which an Exercise-by-Exception (Ex-by- Ex) will occur at expiration to one penny ($0.01) for all account types. This change became effective commencing with the June 2008 standard expiration. Clearing members and their customers (via their broker) can always inform OCC to not exercise a long option position regardless of this threshold, prior to the deadline for such instructions on expiration. Clearing members may also have a different threshold established with OCC, so individual investors are encouraged to consult with their brokerage firm on its procedures. Furthermore, this does not imply that option writers will be assigned with certainty, as the option holder can exercise irrespective of any threshold. As a result of this change, any option that is inthe-money (ITM) at expiration by $0.01 would be automatically exercised in lieu of other instructions. Q: I was expecting Jan LEAPS to be available around May this year, but it appears they are delayed by up to almost six months. Why has that happened? I prefer buying the longest expiration LEAPS possible. A: If the options exchanges listed LEAPS as they had in the past, you would be absolutely correct. However, the exchanges filed and received approval for a delay in listing LEAPS this year. The reason is to evaluate which LEAPS actually warrant listing. The exchanges do not want to generate quotes for products that don't trade. Moreover, the exchanges have added a number of products in the past 18 months such as Weekly and Quarterly options. If you consider the expansion of penny trading and single strikes, there are many more overall quotes being generated. The ideal options strategy, like the ideal investment strategy, is one where the investor is comfortable with and understands the risks involved in carrying out that particular strategy. An investor should also consider his financial goal and his outlook for the underlying security when selecting an options strategy.you can find the new Sep. 15, Oct. 13 and Nov. 17 dates here help/faq/leaps.jsp#5. To keep up-to-date on most options expirations, download OIC s Options Expiration Calendar at I find that collars are an effective stockoption combination for conservative investors...the process of managing the monthly expiration of the covered call portion of this collar position is covered in many excellent books and publications on the subject of the covered call. My choice of book is The Option Trader Handbook, Strategies and Trade Adjustments by George Jabbour and Philip Budwick, published by John Wiley & Sons, This book is not only a clear and concise dissertation on the subject of use of options alone and in concert with stocks, but it devotes a large portion of the book to ways to make trading adjustments to existing option and stock positions as market conditions change. John Gary Boyle - Santa Fe, NM Want to let others know about a strategy that worked great for your portfolio? Have an experience to share about an educational tool that gave you some insight into options trading? The Options Industry Council invites you to submit your options experiences to be featured in Options Central. Send us your testimonials to be featured in our Readers Quotes section for our next issue! Options Central welcomes letters and questions that address articles or other options items. Submit letters to optionscentral@theocc.com. Letter submissions may be edited for space. By submitting any letter, you consent to its publication along with your name. Options Central is under no obligation to print all pieces submitted. Editor s Note - An options investor may not have typical results as stated above as there are multiple, different outcomes from strategies in options trading. OIC does not endorse or have an opinion on the above-mentioned book The Options Trader Handbook, Strategies and Trade Adjustments.

PAGE 7 Upcoming Seminars Check out www.optionseducation.org for a complete description and schedule of fall 2008 OIC seminars.

7 PAGE 7 Upcoming Seminars Check out for a complete description and schedule of fall 2008 OIC seminars. September 16 San Jose - Basic 17 San Jose - Intermediate 17 Cambridge MA - Basic 18 Cambridge MA - Intermediate 23 Minneapolis - Basic 24 Minneapolis - Intermediate 24 Richmond VA - Basic 25 Richmond VA - Intermediate October 14 Parsippany - Basic 15 Parsippany - Intermediate 15 St. Louis - Basic 16 St. Louis - Intermediate 21 Schaumburg IL - Basic 22 Schaumburg IL - Intermediate 22 Boca Raton FL - Basic 23 Boca Raton FL - Intermediate 28 NY Downtown -Basic 29 NY Downtown - Intermediate 29 Los Angeles - Basic 30 Los Angeles - Intermediate November 5 Baltimore - Basic 6 Baltimore - Intermediate 18 New York Midtown - Volatility 19 Santa Ana CA - Volatility 20 Detroit - Volatility One N. Wacker Drive, Suite 500 Chicago, Illinois OPTIONS ( ) Options involve risk and are not suitable for everyone. Prior to buying or selling options, you must read the options disclosure document, Characteristics and Risks of Standardized Options, which can be obtained from your brokerage firm, from any exchange on which options are traded, by calling OPTIONS or by writing The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois Consult your tax advisor for tax considerations. FOR MORE INFORMATION If you have additional questions about options, contact your financial advisor or one of the exchanges listed here. The American Stock Exchange THE-AMEX; Boston Options Exchange ; Chicago Board Options Exchange THE-CBOE; International Securities Exchange ; NASDAQ OMX ; NASDAQ OMX PHLX THE-PHLX; NYSE Arca SM ; The Options Clearing Corporation ; Registration is required. All seminars are FREE and held from 6 p.m. - 9 p.m. To register for a seminar or order educational materials, call OPTIONS or visit

Understanding Covered Calls and Buy-Write Strategies

1-888-OPTIONS www.optionseducation.org YOUR DESTINATION FOR OPTIONS EDUCATION SUMMER 09 Understanding Covered Calls and Buy-Write Strategies By: Bill Ryan In this summer 2009 issue: Feature: Understanding