Warning about the exercise process

Over
the past few years, I have been asked the following questions:

· I own an option
that is out of the money. Must I
exercise it?

· I don’t have the
necessary cash in my account to pay for stock. Do I have to exercise my call option?

· My broker tells
me that I have no choice and must exercise my call option. I don’t want to do it. Was I given bad advice by my broker?

 

For
some reason that I don’t understand, many rookies find themselves asking a
similar question. Let’s be sure each of
you understands this basic point:

*The
owner of a call option has the right, but not the obligation, to take action specified in the option contract. That means the call owner may, if he decides
to do so, exercise the option and buy 100 shares of stock at the strike
price. But, there is no obligation to do
so. The option owner may sell the option
at any time before it stops trading on Expiration Friday. The owner of an option may allow the option
to expire worthless.

*The
owner of a put option has the right, but not the obligation, to take action specified in the option contract. That means the put owner may, if she decides
to do so, exercise the option and sell 100 shares of stock at the strike
price. But, there is no obligation to do
so. The option owner may sell the option
at any time before it stops trading on Expiration Friday. The owner of an option may allow the option
to expire worthless.

To
repeat – you are never obligated to exercise your option. It’s your choice. That’s why it’s called an
option.

NEW RULE
CHANGE

However,
please be aware of a new rule that was adopted by the option exchanges and the
Options Clearing Corporation: Effective
with expiration in June 2008, any option that is in the money when expiration
arrives – even if it’s in the money by only one penny – will be automatically
exercised
for you. In other words,
your rights – the rights you were guaranteed when you bought the option – have been
revoked. I find this to be outrageous and totally unacceptable. But sadly, my opinion doesn’t count.

To
protect yourself from this problem, if you are unable to sell your option and
you don’t want to exercise, it’s now necessary to notify your
broker – shortly after the market closes on expiration Friday – that you DO NOT
want to exercise. If you fail to notify
them, the option will be exercised. Take
the precaution of being certain you know how to deliver that ‘do not exercise’
instruction in case you ever need it. Ask your broker now  how to notify them.

Why
is this such a problem? If the stock is
trading at $50.01, shouldn’t you want to buy it at $50.00? No, you shouldn’t. For one thing your broker probably charges a
fat fee to exercise. If you pay $15 to exercise
an option that’s in the money by one cent, you are already $14 worse off than
before you exercised. And now you own
the stock (if it’s a call option) and probably want to sell it. That costs another commission.

This
rule change is definitely a money-maker for the brokers, but a money loser for
their customers – and that’s you, the individual investor. If I were you, I’d complain bitterly to your
individual brokers that this rule is totally unfair. But, it’s probably tilting at windmills and
nothing will change.

9

 

 

Comments are closed.