Exercising an Option: Who’s in charge?

Important note: There
is one major misconception that is fairly common among option rookies. It leads to a great deal of confusion and I
want to be certain that it never happens to you. This discussion is important enough to
justify its own blog entry.

· The
owner of an option has certain rights.

· The
seller of an option has NO rights.

 

· Only the owner of an option can exercise that option.

· The owner of an option is NOT obligated to exercise, but has the right
to do so.

 

· The owner of an option has
three choices:

o Sell the option.

o Exercise the option.

o Allow the option to expire
worthless.

 

· The seller of an option has
only two choices:

o Repurchase the option sold
earlier – but it must be repurchased before the seller is assigned an exercise
notice. That removes the option from
your portfolio and cancels all obligations.

o 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.

§ Most brokers provide that
information on Sunday, following expiration. But only for online accounts.

 

· The decision to exercise rests entirely with the option owner.

· The option seller may not request that the option be exercised.

· The option seller may not ask the option owner ‘please do not exercise’.

· Once the option is exercised and the option seller is assigned an exercise
notice, the transaction is final. It cannot be undone.

 

· Automatic exercise:

o 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 (almost always 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.

 

o Option owners:

§ May submit instructions to their
brokers, telling them “do not exercise.” This is a reasonable action when the option is only in the money by a
penny or two.

§ Each broker has its own
rules and cutoff time for submitting such a notice. Be certain you are aware of your broker’s requirements.

§ May submit instructions to their
brokers telling them DO exercise, even when the option is out of the
money. This does not happen often, but
it does happen.

 

o Option sellers:

§ May not request that an
option be exercised.

§ May not request than an
option not be exercised.

§ Have no rights. None.

Bottom
line: If you sell options, such as in
covered call writing, you have no say in the decision to exercise that option.

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