Opinion: The New Automatic Exercise Threshold Has Been Reduced to One Cent

Warning: All in-the-money Options are Exercised Automatically. To prevent such options from being exercised on your behalf, you must notify your broker ‘not to exercise’ – and the only day you are allowed to do that is the last day the option trades (typically the 3^rd Friday).

The powers that be, and that means the Option Exchanges and the OCC (Options Clearing Corporation) have deemed that it’s to your advantage to exercise an option when it’s in the money at expiration – even when the intrinsic value (amount that it’s in the money) is only a penny or two. Thus, the threshold for deciding when an option qualifies for automatic exercise has been reduced from five cents to one penny. This change took effect as of June 21, 2008.   Note: Your broker is not responsible for this change and although the broker is the beneficiary of this absurdity, please don’t blame your broker.

 

For most individual investors this change presents no problems.  But for the few whom it will inconvenience, a nasty surprise awaits. It’s true that anyone who owns an option is responsible for knowing whether the option is in the money. It’s also true that the brokers make extensive efforts to notify all option traders. Yet, there are always some people who slip through the cracks. Sometimes careless investors forget about options they own and a sudden change in the stock’s price could result in an option moving beyond the strike price by a penny. I don’t believe it is right to punish these investors.

 

To me this change is wrong.  The reason for the change is to streamlines the exercise process. In other words, it makes their jobs easier and the needs of the individual investor are ignored.  This problem is especially difficult for the options rookie who trades only one or two contracts at a time. Consider this situation:

 

You own one Jul 90 call option on MDWO, and the official closing price on expiration Friday is $90.01 per share. As an intelligent investor, you tried to sell your call, but there were no buyers. Thus, you find yourself owning the call when the stock market closes for trading on the 3^rd Friday of July. Previously, you could ignore the option and allow it to expire worthless. But, that is no longer possible. If you do nothing, the option will be exercised. An option contract specifies that the option owner has the right, but not the obligation, to exercise the option any time before that option expires. This new threshold cancels your rights and forces you to exercise, unless you take specific action to prevent the exercise. When you look at your portfolio Monday morning, you find that you own 100 shares of MDWO and that you paid $90 per share, or $9,000.

Because almost all brokers (there are exceptions) charge a fee to exercise an option (let’s assume the cost is $15), you discover that you paid $15 to own this stock. You also owe interest on $9,000 to carry this position over the weekend. Because you have no intention of owning the stock, you are forced to sell the shares, incurring yet another commission. If lucky, you sell at Friday’s closing price ($90.01). It cost you $15 plus interest plus the sell commission to ‘make’ the $1 of intrinsic value that you gained by being forced to exercise. Wasn’t that nice of those ‘powers that be’ to protect your one dollar of value?

This is not a good deal for the small trader.

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