The Mechanics of Option Trading, Exercise, and Assignment
Options were originally traded in the over-the-counter (OTC) market, where the terms of the contract were negotiated. The advantage of the OTC market over the exchanges is that the option contracts can be tailored: strike prices, expiration dates, and the number of shares can be specified to meet the needs of the option buyer. However, transaction costs are greater and liquidity is less.
Option trading really took off when the first listed option exchange—the Chicago Board Options Exchange (CBOE)—was organized in 1973 to trade standardized contracts, greatly increasing the market and liquidity of options. The CBOE was the original exchange for options, but, by 2003, it has been superseded in size by the electronic International Securities Exchange (ISE), based in New York. Most options sold in Europe are traded through electronic exchanges. Other exchanges for options in the United States include: NYSE Euronext (NYX), and the NASDAQtrader.com.
Option exchanges are central to the trading of options:
- they establish the terms of the standardized contracts
- they provide the infrastructure — both hardware and software — to facilitate trading, which is increasingly computerized
- they link together investors, brokers, and dealers on a centralized system, so that traders can from the best bid and ask prices
- they guarantee trades by taking the opposite side of each transaction
- they establish the trading rules and procedures
Options are traded just like stocks—the buyer buys at the ask price and the seller sells at the bid price. The settlement time for option trades is 1 business day (T+1). However, to trade options, an investor must have a brokerage account and be approved for trading options and must also receive a copy of the booklet Characteristics and Risks of Standardized Options.
The option holder, unlike the holder of the underlying stock, has no voting rights in the corporation, and is not entitled to any dividends. Brokerage commissions, which are a little higher for options than for stocks, must also be paid to buy or sell options, and for the exercise and assignment of option contracts. Prices are usually quoted with a base price plus cost per contract, usually ranging from $5 to $15 minimum charge for up to 10 contracts, with a lower per contract charge, typically $0.50 to $1.50 per contract, for more than 10 contracts. Most brokerages offer lower prices to active traders. Here are some examples of how option prices are quoted:
- $9.99 + $0.75 per contract for online option trades
- $9.99 + $0.75 per contract for online option trades; phone trades are $5 more, and broker-assisted trades are $25 more
- $1.50 per contract with a minimum standard rate of $14.95, with numerous discounts for active traders
- Sliding commission scale ranging from $6.99 + $0.75 per contract for traders making at least 1500 trades per quarter to $12.99 + $1.25 per contract for investors with less than $50,000 in assets and making fewer than 30 trades per quarter. $19.99 for exercise and assignments.
The Options Clearing Corporation (OCC)
The Options Clearing Corporation (OCC) is the counterparty to all option trades. The OCC issues, guarantees, and clears all option trades involving its member firms, which includes all U.S. option exchanges, and ensures that sales are transacted according to the current rules. The OCC is jointly owned by its member firms — the exchanges that trade options — and issues all listed options, and controls and effects all exercises and assignments. To provide a liquid market, the OCC guarantees all trades by acting as the other party to all purchases and sales of options.
The OCC publishes, at optionsclearing.com, statistics, news on options, and any notifications about changes in the trading rules, or the adjustment of certain option contracts because of a stock split or that were subjected to unusual circumstances, such as a merger of companies whose stock was the underlying security to the option contracts.
The OCC operates under the jurisdiction of both the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). Under its SEC jurisdiction, OCC clears transactions for put and call options on common stocks and other equity issues, stock indexes, foreign currencies, interest rate composites and single-stock futures. As a registered Derivatives Clearing Organization (DCO) under CFTC jurisdiction, the OCC clears and settles transactions in futures and options on futures.
The Exercise of Options by Option Holders and the Assignment to Fulfill the Contract to Option Writers
When an option holder wants to exercise his option, he must notify his broker of the exercise, and if it is the last trading day for the option, the broker must be notified before the exercise cut-off time, which will probably be earlier than on trading days before the last day, and the cut-off time may be different for different option classes or for index options. Although policies differ among brokerages, it is the duty of the option holder to notify his broker to exercise the option before the cut-off time.
When the broker is notified, then the exercise instructions are sent to the OCC, which then assigns the exercise to one of its Clearing Members who are short in the same option series as is being exercised. The Clearing Member will then assign the exercise to one of its customers who is short in the option. The customer is selected by a specific procedure, usually on a first-in, first-out basis, or some other fair procedure approved by the exchanges. Thus, there is no direct connection between an option writer and a buyer.
To ensure contract performance, option writers are required to post margin, the amount depending on how much the option is in the money. If the margin is deemed insufficient, then the option writer will be subjected to a margin call. Option holders don't need to post margin because they will only exercise the option if it is in the money. Options, unlike stocks, cannot be bought on margin.
Because the OCC is always a party to an option transaction, an option writer can close out his position by buying the same contract back, even while the contract buyer retains his position, because the OCC draws from a pool of contracts that have no connection to the original contract writer and buyer.
Example—No Direct Connection between Investors Who Write Options and those Who Buy Them
John Call-Writer writes an option that legally obligates him to provide 100 shares of Microsoft for the price of $30 until April, 2007. The OCC buys the contract, adding it to the millions of other option contracts in its pool. Sarah Call-Buyer buys a contract that has the same terms that John Call-Writer wrote—in other words, it belongs to the same option series. However, option contracts have no name on them. Sarah buys from the OCC, just as John sold to the OCC, and she just gets a contract giving her the right to buy 100 shares of Microsoft for $30 per share until April, 2007.
Scenario 1—Exercises of Options are Assigned According to Specific Procedures
In February, the price of Microsoft rises to $35, and Sarah thinks it might go higher in the long run, but since March and April generally are volatile times for most stocks, she decides to exercise her call (sometimes referred to as calling the stock) to buy Microsoft stock at $30 per share to be able to hold the stock indefinitely. She instructs her broker to exercise her call; her broker forwards the instructions to the OCC, which then assigns the exercise to one of its participating members who provided the call for sale; the participating member, in turn, assigns it to an investor who wrote such a call; in this case, it happened to be John's brother, Sam Call-Writer. John got lucky this time. Sam, unfortunately, either has to turn over his appreciated shares of Microsoft, or he'll have to buy them in the open market to provide them. This is the risk that an option writer has to take—an option writer never knows when he'll be assigned an exercise when the option is in the money.
Scenario 2—Closing Out an Option Position by Buying Back the Contract
John Call-Writer decides that Microsoft might climb higher in the coming months, and so decides to close out his short position by buying a call contract with the same terms that he wrote—one that is in the same option series. Sarah, on the other hand, decides to maintain her long position by keeping her call contract until April. This can happen because there are no names on the option contracts. John closes his short position by buying the call back from the OCC at the current market price, which may be higher or lower than what he paid, resulting in either a profit or a loss. Sarah can keep her contract because when she sells or exercises her contract, it will be with the OCC, not with John, and Sarah can be sure that the OCC will fulfill the terms of the contract if she should decide to exercise it later on.
Thus, the OCC allows each investor to act independently of the other.
When the assigned option writer must deliver stock, she can deliver stock already owned, buy it on the market for delivery, or ask her broker to go short on the stock and deliver the borrowed shares. However, finding borrowed shares to short may not always be possible, so this method may not be available.
If the assigned call writer buys the stock in the market for delivery, the writer only needs the cash in his brokerage account to pay for the difference between what the stock cost and the strike price of the call, since the writer will immediately receive cash from the call holder for the strike price. Similarly, if the writer is using margin, then the margin requirements apply only to the difference between the purchase price and the strike price of the option. Full margin requirements, however, apply to shorted stock.
An assigned put writer will need either the cash or the margin to buy the stock at the strike price, even if he intends to sell the stock immediately after the exercise of the put. When the call holder exercises, he can keep the stock or immediately sell it. However, he must have the margin, if he has a margin account, or cash, for a cash account, to pay for the stock, even if he sells it immediately. He can also use the delivered stock to cover a short in the stock. (Note: the reason for the difference in equity requirements is because an assigned call writer immediately receives the cash upon delivery of the shares, whereas a put writer or a call holder that purchased the shares may decide to keep the stock.)
Example—Fulfilling a Naked Call Exercise
A call writer receives an exercise notice on 10 call contracts with a strike of $30 per share on XYZ stock on which she is still short. The stock currently trades at $35 per share. She does not own the stock, so, to fulfill her contract, she has to buy 1,000 shares of stock in the market for $35,000 then sell it for $30,000, resulting in an immediate loss of $5,000 minus the commissions of the stock purchase and assignment.
Both the exercise and assignment incur brokerage commissions for both holder and assigned writer. Generally, the commission is smaller to sell the option than it is to exercise it. However, there may be no choice if it is the last day of trading before expiration. Although the buying and selling of options is settled in 1 business day after the trade, settlement for an exercise or assignment occurs on the 3rd business day after the exercise or assignment (T+3), since it involves the purchase of the underlying stock.
Often, a writer will want to cover his short by buying the written option back on the open market. However, once he receives an assignment, then it is too late to cover his short position by closing the position with a purchase. Assignment is usually selected from writers who are still short at the end of the trading day. A possible assignment can be anticipated if the option is in the money at expiration, the option is trading at a discount, or the underlying stock is about to pay a large dividend.
The OCC automatically exercises any option that is in the money by at least $0.50 (automatic exercise, Exercise-by-Exception, Ex-by-Ex), unless notified by the broker not to. A customer may not want to exercise an option that is only slightly in the money if the transaction costs would be greater than the net from the exercise. In spite of the automatic exercise by the OCC, the option holder should notify his broker by the exercise cut-off time, which may be before the end of the trading day, of an intention to exercise. Exact procedures will depend on the broker.
Any option that is sold on the last trading day before expiration would likely be bought by a market maker. Because a market maker's transaction costs are lower than for retail customers, a market maker may exercise an option even if it is only a few cents in the money. Thus, any option writer who does not want to be assigned should close out his position before expiration day if there is any chance that it will be in the money even by a few pennies.
Sometimes, an option will be exercised before its expiration day—called early exercise, or premature exercise. Because options have a time value in addition to intrinsic value, most options are not exercised early. However, there is nothing to prevent someone from exercising an option, even if it is not profitable to do so, and sometimes it does occur, which is why anyone who is short an option should expect the possibility of being assigned early.
When an option is trading below parity (below its intrinsic value), then arbitrageurs can take advantage of the discount to profit from the difference, because their transaction costs are very low. An option with a high intrinsic value will have very little time value, and so, because of the difference between supply and demand in the market at any given moment, the option could be trading for less than its true worth. An arbitrageur will almost certainly take advantage of the price discrepancy for an instant profit. Anyone who is short an option with a high intrinsic value should expect a good possibility of being assigned an exercise.
Example—Early Exercise by Arbitrageurs Profiting from an Option Discount
XYZ stock is currently at $40 per share. Calls on the stock with a strike of $30 are selling for $9.80. This is a difference of $0.20 per share, enough of a difference for an arbitrageur, whose transaction costs are typically much lower than for a retail customer, to profit immediately by selling short the stock at $40 per share, then covering his short by exercising the call for a net of $0.20 per share minus the arbitrageur's small transaction costs.
Option discounts will only occur when the time value of the option is small, because either it is deep in the money or the option will soon expire.
Option Discounts Arising from an Imminent Dividend Payment on the Underlying Stock
When a large dividend is paid by the underlying stock, its price drops on the ex-dividend date, resulting in a lower value for the calls. The stock price may remain lower after the payment, because the dividend payment lowers the book value of the company. This causes many call holders to either exercise early to collect the dividend, or to sell the call before the drop in stock price. When many call holders sell at the same time, it causes the call to sell at a discount to the underlying, thereby creating opportunities for arbitrageurs to profit from the price difference. However, there is some risk that the transaction will lose money, because the dividend payment and drop in stock price may not equal the premium paid for the call, even if the dividend is more than the time value of the call.
Example—Arbitrage Profit/Loss Scenario for a Dividend-Paying Stock
XYZ stock is currently trading at $40 per share and is going to pay a dividend of $1 the next day. A call with a $30 strike is selling for $10.20, the $0.20 being the time value of the premium. So an arbitrageur decides to buy the call and exercise it to collect the dividend. Since the dividend is $1, but the time value is only $0.20, this could lead to a profit of $0.80 per share, but on the ex-dividend date, the stock drops to $39. Adding the $1 dividend to the share price yields $40, which is still less than buying the stock for $30 plus $10.20 for the call. It might be profitable if the stock does not drop as much on the ex-date or it recovers after the ex-date sufficiently to make it profitable. But this is a risk for the arbitrageur, and this transaction is, thus, known as risk arbitrage, because the profit is not guaranteed.