Exercise Danger!

Would you ever sign a contract without knowing what you were signing? Hopefully the answer is no. Remember when you are trading options that you are signing a contract.

The simplest definition of an option is that it is a contract. Contracts have rights and obligations.

An option contract is the right to buy or sell an underlying security at a set price on or before a set date. For example, we may buy an option contract that gives us the right to purchase shares of a stock for $50 per share at any time within the next 90 days. In this example $50 is the strike price and the expiration date is in 90 days.

Exercising an option is the terminology used when putting into effect the conditions of the contract. In our example, we have the right to purchase a stock for $50 per share. If we exercise our right, we are choosing to purchase the stock for $50 per share. A standard option represents 100 shares of stock so that would cost us $5,000 plus whatever fees and commissions we owe.

There are two common types of equity options. European style and American style. American style options can be exercised at any time up to expiration. European style options can only be exercised at expiration. Most stocks and ETF options trade American style. Most index options trade European style. You should contact your broker if you are not completely sure which type of option you are trading.

Most options are not exercised. They either expire out of the money or are offset by closing positions prior to expiration. Most options that do get exercised get exercised at expiration, however, early exercise is a possibility on American style options.

The OCC (Options Clearing Corporation) uses a process known as exercise by exception to exercise options at expiration. Simply put, options that are in the money by the threshold amount will be exercised at expiration unless the OCC is instructed otherwise. Since June of 2008 the OCC has had an exercise threshold of $0.01. That means any option that is in the

money by $0.01 or more will be exercised at expiration unless the OCC is instructed otherwise. Individual brokerage firms may have a different threshold for exercise from the OCC.

Generally speaking it is safe to say that options that are in the money will be exercised at expiration. If you are unsure of whether your option is in the money or not please don’t hesitate to reach out to your broker for additional assistance.

Managing Trades

It is critical that we are aware of exactly what we are investing in. Since options are contracts we need to be sure that we understand our contractual rights and obligations. If our options are in the money at expiration they will be exercised.

For example, if we own a long call at expiration and it expires in the money we will end up buying the stock at the strike price of the call. We would then be responsible for the full risk of the stock position.

If we are short an in the money call at expiration we would be obligated to sell the stock. If we already own the stock then we have to sell it. If we don’t own the stock then we have to borrow the stock from the broker and sell it anyway. This means we are short the stock and are responsible for the full risk of the short stock position.

Early Exercise

American style options can be exercised at any time. Options that are deep in the money have a higher chance of getting exercised early. This is because they are made up of mostly intrinsic value. If an in the money option has little or no extrinsic value remaining then it has a high chance of being exercised early.

Let’s say we sold a $45 strike call. The stock is now trading for $50 per share. The call option is trading for $4.85 per share. The buyer of the call has a choice. They can choose to sell the call for $4.85 or they can exercise the call and purchase the stock for a $5 discount. Mathematically it makes sense for them to exercise the call early. As the seller of the call, we would be obligated to sell the stock for $45 per share. This could happen at any time. This is why it is so important to manage our trades properly and be aware of our contractual rights and obligations.

When we short a call we are also exposed to dividend risk. Since selling a call requires us to sell a stock if exercised we could find ourselves short a stock through a dividend. When short a stock we are responsible for paying that dividend to the owner of the stock we borrowed. If the dividend payout on a stock exceeds the extrinsic value of an in the money calls corresponding put, then that call is in danger of getting exercised early.

Let’s say there is a $50 stock that is issuing a $1 dividend. We own a $48 strike call on that stock. If the $48 strike put is trading for less than $1 then our call is in danger of getting exercised early for the dividend.

Education

Options useful tools when used properly. As option traders it is our responsibility to master the

fundamentals of options; be aware of the contractual rights and obligations involved in options, understand how options are priced, master risk management techniques, master basic option strategies such as long options and covered options, and learn vertical spreads and other more advanced strategies.

Most importantly, control risk. Options are leveraged instruments and leverage works both ways. Know what the maximum loss is. Don’t invest with money you can’t afford to lose. Don’t be intimidated by options. They are wonderful tools. Have fun learning, be safe, and allow us to assist you in this journey.