Option Basics: Exercise

Converting an Option into Stock

Options Education: The Basics
Options Education: The Basics. Google Images

There is a common misunderstanding among rookie option traders, but readers of this article will be spared that confusion.

I'm sure you all know about one of the basic concepts of options: Option owners have the right to exercise call or put options at any time before the option expires. But do you truly understand what that means in practical terms? The following discussion should clear up any misconceptions.

When someone pays the premium and purchases an option, he/she gets something in return for paying that cash. In addition, the option seller receives cash and you should recognize that the cash is not a gift, but that the seller must agree to certain conditions (referred to as obligations). Thus,

  • The owner of an option has specific rights.
  • The seller of an option has NO rights, other than the right to cover (i.e., buy the option sold previously) before he/she is notified that the option owner exercised the option.

The Rights of an Option Owner

  • The owner of an option has the right to do one of three things with that option.

                     Exercise the option. 
                     Sell the option.
                     Allow the option to expire worthless.

  • The owner of an option is NOT obligated to exercise but has the right to do so. In other words, the owner has the choice, or option, to convert the option into a stock position.

    Note Option owners prefer not to allow options to expire worthless, but sometimes options out of the money when expiration arrives -- making it too late to sell the option -- and there is no reason to exercise a call when the stock is available below the strike. Similarly, there is no reason to exercise an out-of-the-money put when the stock can be sold above the strike.

    The Option Seller May:

    The option seller has only two choices:

    • Cover the option sold before the seller is . That removes the option from the seller's portfolio and cancels all obligations.
    • Wait for expiration to learn whether you have been assigned an exercise notice.
      • That notification arrives before the market opens for trading on the business day following expiration. Many brokers offer that information a day earlier -- but only online.

    The Option Seller May Not:

    • The option seller may not request that the option be exercised.
    • The option seller may not ask the option owner "please do not exercise."
    • The decision to exercise belongs to the option owner.
    • When the option is exercised by its owner and the option seller is assigned an exercise
      notice, the transaction is final and the option seller is obligated to honor the conditions of the option contract (i.e., the call seller must sell 100 shares at the strike price; the put seller must buy 100 shares at the strike price).

    Automatic Exercise

    Sometimes an option is subject to automatic exercise. Translation: An option may be exercised, even when the option owner does not notify the broker that he/she wants to exercise. The rule is simple:

    • If an option is in the money by one penny or more, it is automatically exercised. The "closing price" of the underlying stock that determines whether an option qualifies for automatic exercise is the last tick on the primary exchange on which the stock trades (usually the NYSE or NASDAQ) on the last day that the option trades (usually the 3rd Friday of the month). If the stock moves above or below the strike price AFTER the market closes on expiration Friday, that price change is ignored for the purposes of the automatic exercise rule.

      Option owners have other rights.

      • They may submit a DO NOT EXERCISE notice for an in-the-money option when it is ITM by only a penny or two. Why would they do that? Because the broker charges a fee to exercise, making the after-commission purchase price too high. It is better for individual investors to simply allow those options to expire worthless. NOTE: It is better yet to sell those options, but sometimes there are no bids.
      • They may submit DO EXERCISE instructions to their brokers, even when the option is out of the money. This does not happen often, but sometimes it is necessary to exercise an option, even when it is out of the money by one penny when a call owner wants to offset an existing short stock position.
      • Note: Each broker has its own rules and cutoff time for submitting such notices. Be certain you are aware (in advance) of your broker’s requirements.