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Obligations and Rights of an Option Trader

As I reply to questions or visit investment forums, I repeatedly encounter option beginners who are surprised by what they discover after making option trades.

That's equivalent to paying money to enter a tournament, knowing the competition is out to take your money, and not bothering to learn the rules before getting started.

Yet it happens all the time.  Today's blog post is devoted to investors who are about to become option traders.  It's also dedicated to those who have already started, without being prepared. 

In an attempt to eliminate some of the many surprises that can occur when you don't know the ground rules, this discussion covers the rights and obligations of option traders.

Rights

Option owners acquire certain rights when they buy an option.

Option sellers have no rights.  None.

An option owner has the right to exercise the option. 

Please note that this is a right, and not an obligation

If you, the call or put owner don't want to exercise the option, that's perfectly acceptable.  Some rookies fear they may be required to exercise.  If that were true, no one would ever purchase a call or put option.

You can sell the option (assuming it is not so worthless that no one will pay anything for it).

You can hold it through the expiration date.  When that date arrives, if you have neither sold nor exercised the option, it expires and officially becomes worthless.

Warning:  When expiration arrives, if you own an option that is in the money (by any amount) it will automatically be exercised.  Thus, if you own such an option, and want that option to expire worthless, it's very important that you sell it – or notify your broker (immediately after the market closes on expiration Friday) 'do not exercise' those options.

Why wouldn't you want to exercise?  If you own one call option with a strike price of 30, would you pay your broker a fee of $15 for the right to buy 100 shares @ $30.02?  I hope you wouldn't.  If you want those shares, it's cheaper to buy them @ $30.02 and throw away the option.  Too many brokers charge excessive fees to exercise an option.  They also charge far too much when you are assigned an exercise notice.

Editorial comment: When expiration arrives, the powers that be – specifically the money-hungry brokers who charge a commission to exercise an option (or to be assigned an exercise notice) – convinced the rule-makers that your rights should be terminated.  Your RIGHT to exercise becomes an OBLIGATION to exercise, unless you take steps to opt out.  I have no idea why there has not been a huge class-action lawsuit against the brokerage industry for imposing this rule.

Obligations

When you sell an option, along with the cash proceeds, you become obligated to honor that contract.  Thus, if the option is exercised and your broker informs you that you have been assigned an exercise notice (this simply means that your account was randomly selected as a counterparty to someone who exercised the option), you must fulfill your commitment.  It's too late to do anything.

If assigned when short a call option, you must sell 100 shares of the underlying stock at the strike price.  You deliver the shares and receive the cash.  If you don't own the shares, then they are sold short for your account.

If assigned when short a put option, you must buy 100 shares by paying the strike price.  The shares are deposited into your account, and the cash to pay for those shares is removed.  If you don't have enough cash, your broker will lend it to you (under certain conditions).  If you cannot meet those conditions, then you receive a margin call – a very unpleasant – something to be avoided – situation.

NOTE:  You are not always going to receive an assignment notice.  Sometimes the options you sold expire worthless and your obligations are canceled.  The only way to guarantee that you are not assigned an exercise notice is to repurchase the option sold earlier.  That repurchase (buy to close) must be made prior to receiving an exercise notice.  One that notice has been received, it's too late to do anything about it.  The exercise is irrevocable and you must honor the conditions of the option contract.

It's not difficult to understand your rights and obligations as an option buyer/seller.  Please be certain you do understand them before trading.

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