One of the first things a new option trader learns is that the owner of an option has the right, but not the obligation, to exercise that option. For many, that’s as much as they ever learn about the exercise process. And that’s not nearly enough.
To make the best option trades, stock option traders should understand these 6 key concepts about the option exercising decision:
1) Don’t exercise. Although an option owner has the right to exercise, it’s seldom a good decision. It’s far easier (and less expensive) to sell an option than to exercise. Although there are specific situations in which exercising is worthwhile, as a newcomer to the options universe, you can wait to learn about these exceptions.
2) ‘But not the obligation’ is a crucial part of the sentence at the top of this article, but it’s often ignored. I have been asked whether an option must be exercised. When you own an option, it’s your choice. You may sell an option, allow it to expire worthless, or exercise. But the choice is yours.
3) Automatic exercise. There is one (absurd, in my opinion) exception to the right vs. obligation issue. When expiration arrives, if the option is in the money by one penny or more (that means it has an intrinsic value of more than zero), the powers that be have decided that they have the right to break the contract and force you to exercise – unless you issue specific instructions to your top discount broker: “Do not exercise.”
That’s an unfair burden, but the rules were written to make money for your broker, not to protect you. Those ‘do not exercise’ instructions must be submitted shortly after the market closes on expiration Friday. If you own an option and are unable to sell it (because there are no bids), and if you don’t want to exercise, learn your broker’s notification method NOW, so you have the information handy, when it’s needed.
NOTE: This is a choice that only the option owner can make. If you are short the option, you may NOT request anything.
4) When you sell an option, you have no rights. Instead, you have an obligation. If the option expires worthless, then your obligation is canceled. If you are assigned an exercise notice (that means the option owner has exercised the option), then you are obligated to fulfill the conditions of the option contract. Once the option has been exercised, the option is canceled and no longer exists.
- If you are assigned an exercise notice on a call option, you must sell 100 shares of the underlying stock. You receive the strike price per share. You don’t have to do anything. Your broker takes care of the process for you. When you see your statement in the morning, it will show that you sold 100 shares overnight.
- If assigned on a put option, you must buy 100 shares of the underlying stock at the strike price. Again, the process is automatic.
- Thus, you cannot request or demand that the option owner exercise the option. You cannot request that the option be allowed to expire worthless. You can do nothing except wait for the decision of the option owner.
- The only action you can take – if you don’t want to be assigned an exercise notice – is to purchase the identical option you sold earlier. That purchase cancels your obligation – but only when you buy that option before you are assigned an exercise notice. Once you receive that notice, the exercise process has been completed and cannot be reversed. You may trade to eliminate the stock position from your portfolio, but the exercise/assignment cannot be undone.
5) Some index options ‘settle in cash.’ These are European options and there is no need for you to be concerned about this for the moment. No shares exchange hands. Instead, the option is canceled and the intrinsic value of the option is transferred (in cash) from the person who was assigned an exercise notice to the person who exercised the option.
6) Similar terms. These option terms are often used interchangeably, but they all have the same meaning:
- Assigned an exercise notice
- Received an exercise notice
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