Exercising an Option

Exercise and Assignment. Part 1

Close-Up Of Calendar Date
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The Basics

If you plan to trade options, it is mandatory to have a basic idea of how the process works. For example, you should know that "the option owner has the right, but not the obligation to exercise." However, for all practical purposes, it is far more efficient to sell the option, rather than exercise. 

The owner of a call option has the right to exercise the option and thereby purchase 100 shares of the underlying asset (stock or ETF) by paying the strike price per share.

That right evaporates when the option expires -- shortly after the close of business on the date specified in the option contract. Most often that expiration occurs on the 3rd Friday of the month.

The owner of a put option has the right to exercise the option and thereby sell 100 shares of the underlying asset (stock or ETF) and receive the strike price per share. That right evaporates once the option expires.

Exercise

When the option owner elects to do what the contract allows, the terminology used is that the owner "exercises his/her rights." Thus, 

  • When a call owner exercises rights, he/she buys 100 shares at the strike price.
  • When a put owner exercises rights, he/she sells 100 shares at the strike price.

The Process

The call owner notifies the broker of a desire to exercise an option. Once that notice is given, it cannot be revoked. In other words, it's a done deal. The cutoff time for exercising an option is shortly after the market closes for trading each business day.

However, it is possible that your broker requires an earlier notification (perhaps five minutes earlier). The best practice is for you to ask your broker's customer service department to explain how they want to be notified and the cutoff time. Most likely they will tell you to notify them via the Internet, but they may accept a telephone call.

It is your responsibility to understand the process. If your broker is not notified of your intention in a timely manner, then the option will not be exercised until the following day. NOTE: On expiration day, automatic exercise occurs -- if the option is in the money by one penny or more.

When the broker is notified, it notifies the OCC (Options Clearing Corporation). The OCC completes the process, and there is nothing for you to do. The "trade" occurs overnight, and when you see your positions in the morning, you will notice some changes.

If you exercised a call option, you bought 100 shares

  • The cash to pay for those shares has been removed from your account (stock purchases settle in three business days, so the cash will not be removed for another two business days).
  • The option has been "used" and no longer exists. Thus, you will not see the option position in your account.
  • For tax purposes, you bought the stock yesterday (the date of exercise); the price of purchase is the sum of two items: The strike price PLUS the cost (premium) of the option.

If you exercised a put option, you sold 100 shares

  • If you owned those shares, they were sold and are no longer in your account.
  • If you did not own the shares, then they were sold short and a short position appears in your account.
  • The cash for selling the shares will be in your account in two business days.
  • The put option has been used and no longer exists
  • For tax purposes, you sold stock yesterday. The sale price equals the strike price MINUS the option cost (premium).

Something you may not expect

Once you buy or sell an option, you are disconnected from the person with whom you made the trade. You never have to be concerned with whether the other party can honor the contract. If and when you elect to exercise, the OCC guarantees the validity of all options contracts and they oversee the exercise process.

You may want to know: When you exercise a call option, who sells the stock? After all, the stock is supposedly above the strike price, so who would sell it at the strike price? Answer: You buy stock from another person who sold the specific option that you are exercising.

That person is obligated to deliver that stock -- at the strike price -- regardless of the current market price.