Exercising OTM Options

Here's an unusual question I received last night.

Mark

As I have learned, 1 (one)
stock option contract gives me the right, but not the obligation, to
buy (for a call option) or sell (for a put option) a specific amount of
a given stock at a specific price during a specified period of time.

Let’s say that in October I decide to purchase 1000 “far out-of-the
money” Microsoft call options for 1 dollar apiece at a $25 strike
price (Microsoft October 25 calls). The total premium is $1000. [Note: "One dollar apiece means the option price is $0.01 and the cost is $1 per contract.]

But, since each contract is worth 100 shares, those contracts are
technically worth 100,000 shares of stock. After several weeks, it
becomes fairly clear that my strike price isn’t going to get hit—the
stock has been trading steadily at $23. However, I still have the right
to exercise the options at $25.

In the above scenario, I decide to exercise all 1000 of my options
regardless of the fact that they are not in-the-money. Isn’t the seller still required to deliver 100,000 shares? If so, that would mean
that 100,000 shares would still be taken from his account and put in my
account. I now have 100,000 Microsoft shares in my account, at which
point it’s up to me to sell them on the open market. Do I have this
correct?

1) Yes, you have the right to exercise those 1,000 call options.

2) Your broker may interfere, telling you that you have made an error.  Thus, if you truly want to exercise, you must be certain your broker knows (use the telephone) your desires and does not automatically stop the exercise from happening.

3) No, the 'seller' is not required to deliver anything.  The Options Clearing Corporation (OCC) randomly chooses, from among all brokers who have accounts that are short that option,  one broker and assigns that broker an exercise notice.

Next that broker using one of two methods: random selection or oldest position first, assigns that exercise notice to one of his account holders.  Assuming this account is not short 1,000 of these calls, a 2nd, 3rd etc. account is chosen to receive an exercise notice. That continues until all 1,000 contracts are assigned.

If that broker's customers, in the aggregate, are not short 1,000 contracts (the OCC knows the exact number when it begins the process), then the next randomly chosen broker is assigned an exercise notice.  The process continues until all assignments have been accounted for.

It's possible that the original seller will be assigned, but with a very large open interest, more likely he/she will not be assigned.

4) Yes, you would have 100,000 shares of MSFT in your account, but there is no way to know the source of those shares.  Your original $1,000 investment has now cost you $2,500,000 (that money went to the various investors who received those assignment notices, $2,500 for each option assigned).  If you cannot meet the margin requirement, you will be forced to sell some, or all of those shares.

5) Yes, it's your decision.  If you meet the margin requirement, you may hold the shares or sell them.  It's your choice.  But, if you cannot meet the margin call, it's no longer 'up to you,' because your broker will force you to sell.

***

NOTE:  Although I have never seen options exercised when they were $2 out of the money, don't be surprised if you are occasionally assigned when an option is only a penny or two out of the money.

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3 Responses to Exercising OTM Options

  1. dave 11/14/2008 at 7:43 AM #

    I thought it was impossible to excersise an option that was out of the money. The contractual obligation is based on the strike price and therefore if it is not above or below the strike than you have no right and thus cannot excersise or be assigned if you are the seller. Please help me here if i am misinformed I never heard of this before. Thanks
    Dave

  2. Mark 11/14/2008 at 8:06 AM #

    You are misinformed.
    The owner of an American style option has the RIGHT to exercise any option at any time before it expires. Period.
    As a seller, you can be assigned. There is no protection against this.
    Years ago, a stock ended at 14 15/16 and I was assigned on the 15 calls.
    Mark

  3. Mike S. 01/05/2009 at 9:22 AM #

    Mark, once again, thanks for answering my questions. I can’t think of a better blog than this one. As a followup to the above:
    There is one thing I’m still confused about though, and that is the actual exercising of the options.
    From what I understand, once my option is in-the-money, after I’ve exercised the option, the only thing that happens is the shares are delivered into my account. I’ve either taken a long or a short position. After that, I still have to sell or buy the shares in order to make a profit. That means that I have to be watching the bid (long position) and the ask price (short position) of the underlying stock immedietly after they are exercised to make sure that those values are still higher or lower than the strike price of the option’s.
    If the above is true, and I am correct, what is the lag time between the time that I exercise the options and when they are actually delivered into my account? If the lag time is long enough, the stock price could have easily changed by the time I can actually buy or sell them. In other words, isn’ it possible that they would no longer be in-the-money by the time they are delivered?