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 3rd 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 3rd 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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