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 The CBOE was the original exchange for options, but, by 2003, it has been superseded in size by the electronic Nasdaq International Securities Exchange (ISE), based in New York.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: New York Stock Exchange, and the NASDAQtrader.com.
Option exchanges are central to the trading of options:
- they establish the terms of the standardized contracts
- they provide the computerized infrastructure — both hardware and software — to facilitate trading
- they link together investors, brokers, and dealers on a centralized system, so that traders get the best bid/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 are still charged for options even though the commissions for stocks have been free for a while. Prices for most options range from $0.65 to $1 per contract.
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, including 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, like other clearing companies, is the direct participant in every purchase and sale of an option contract. When option writers or holders sell their contracts, the OCC serves as an intermediary in the transaction. Option writers sell their contracts to the OCC and option buyers buy from the OCC.
The OCC publishes 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
The OCC requires that in-the-money (ITM) contracts be exercised automatically. Option holders who want to exercise their options before then must notify their 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 may be earlier than on trading days before the last day, and the cut-off time may differ 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 must 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 her position, because the OCC draws from a pool of contracts with no connection to the original contract writer and buyer.
A diagram outlining the exercise and assignment of a call.
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 JXYZ for the price of $30 until April. 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 JXYZ for $30 per share until April.
Scenario 1 — Exercises of Options are Assigned According to Specific Procedures
The price of JXYZ rises to $35, and Sarah wants to collect the dividend, so she exercises her call (sometimes called calling the stock) to buy JXYZ stock at $30 per share. 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 must turn over his appreciated shares of JXYZ, or he'll have to buy them in the open market to provide them. This is the risk that an option writer must 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 JXYZ 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 option contracts are traded with the OCC, not individual traders. John closes his short position by buying the call back from the OCC at the 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 exercises it later.
Thus, the OCC allows each investor to act independently of the other.
The assigned option writer can deliver stock already owned, buy it on the market for delivery, or ask their 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: equity requirements differ because an assigned call writer immediately receives the cash upon delivery of the shares, whereas a put writer or a call holder who 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 JXYZ 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 must 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 possible commissions of the stock purchase and assignment.
Both the exercise and assignment may incur brokerage commissions for both holder and assigned writer. The commission may be higher 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. Both the buying and selling of options and the exercise or assignment are settled in 1 business day after the trade (T+1).
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 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 $0.01 (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 transaction costs exceed the net profit from the exercise or if funds are insufficient for the exercise. If the option holder does not want to exercise the option, the holder should submit a Do Not Exercise (DNE) request to their broker before expiration. Exact procedures for the request depend on the broker.
Early Exercise
Sometimes, an option will be exercised before its expiration day — called early exercise, or premature exercise. Because options have 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, so anyone 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 profit from the discount. An option with a high intrinsic value will have 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. Arbitrageurs profit instantly from this price discrepancy. Anyone 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
JXYZ stock is currently at $40 per share. Calls on the stock with a strike of $30 are selling for $9.80. This $0.20 per share difference allows an arbitrageur to profit immediately by selling the stock short at $40 per share, then covering the short by exercising the call for a net of $0.20 per share minus some 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.
Special Exercise and Assignment Risks
OCC Rule 805 requires that all in-the-money contracts be exercised unless instructed otherwise. However, many option holders may not have the money to exercise the option. Furthermore, there may not be a bid price on the contract, so the option holder may not be able to sell the contract to close it out. Though many brokers modify their policy by not exercising options if the account has insufficient funds, it would be prudent for the option holder to submit a Do Not Exercise (DNE) request to their broker for any option that may be in the money by expiration if they do not want to exercise the option. The method of submitting this request depends on the broker. Some brokers allow submitting a DNE request through their trading platform, but other brokers require calling them on the phone.
Pin risk is another form of assignment risk for the option writer. Pin risk exists when the stock price is the same as the strike price at expiration. Though this rarely happens, an assignment risk still exists if news comes out after the market closes but before the exercise decision deadline that moves the stock price favorably for the option holder, making it more likely that the option will be exercised. FINRA Rule 2360 sets the exercise cut-off time for expiring options at 5:30 PM Eastern Time on the day of expiration. Brokers may set an earlier time, but they may not set a later time.
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 once, the calls sell at a discount to the underlying, creating opportunities for arbitrageurs to profit from the price difference. However, there is risk 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 exceeds the time value of the call.
2019 Statistics for the Fate of Options
Data Source: https://www.optionseducation.org/referencelibrary/faq/options-exercise
All option writers who didn't close out their position earlier by buying an offsetting contract made the maximum profit — the premium — on those contracts that expired. Option writers have lost at least something when the option is exercised, because the option holder wouldn't exercise it unless it was in the money. The more the exercised option was in the money, the greater the loss is for the assigned option writer and the greater the profits for the option holder. A closed out transaction could be at a profit or a loss for both holders and writers of options, but closing out a transaction is usually done either to maximize profits or to minimize losses, based on expected changes in the price of the underlying security until expiration.