Exercise (options)
Encyclopedia
The owner of an option
contract may exercise it, indicating that the financial transaction specified by the contract is to be enacted immediately between the two parties, and the contract itself is terminated. When exercising a call
, the owner of the option purchases the underlying shares at the strike price
from the option seller, while for a put
, the owner of the option sells the underlying to the option seller.
calls just prior to an ex-dividend date. Quite often, non-professional option traders may not understand the benefit of exercising a call option early, and therefore may unintentionally forego the value of the dividend. The professional trader may only be 'assigned' on a portion of the calls, and therefore profits by receiving a dividend on the stock used to hedge the calls that are not exercised.
(OCC). The OCC fulfills the contract, then selects, randomly, a member firm who was short the same option contract. The OCC then notifies the firm. The firm then carries out its obligation, and then selects a customer, either randomly, first-in, first-out, or some other equitable method who was short the option, for assignment. That customer is assigned the exercise requiring him to fulfill the obligation that he agreed to when he wrote the option.
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
contract may exercise it, indicating that the financial transaction specified by the contract is to be enacted immediately between the two parties, and the contract itself is terminated. When exercising a call
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
, the owner of the option purchases the underlying shares at the strike price
Strike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
from the option seller, while for a put
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
, the owner of the option sells the underlying to the option seller.
Exercise Type
The option style determines when, how, and under what circumstances, the option holder may exercise. It also lets the player chose whether he wants in or out- European - European-style option contracts may only be exercised at the option's expirationExpiration (options)For an option contract, expiration is the date on which the contract expires. The option holder must elect to exercise the option or allow it to expire worthless.Typically, option contracts expire according to a pre-determined calendar. For instance, for U.S...
date. These contracts may not undergo early exercise, and therefore can never be worth more than an American-style option of the same strike price and expiration date. - American - American-style option contracts can be exercised at any time up to the option's expiration. Under certain circumstances (see below) early exercise may be advantageous to the option holder.
- Bermudan - Bermudan-style options contracts may only be exercised on specified dates. Bermudan-style options are common in the interest rate options and swaps markets.
Settlement Type
At exercise, the option contract specifies the manner in which the contract is to be settled.- Physical settlement - Physically settled options require the actual delivery of the underlying security. Examples of physically settled contracts include U.S.-listed exchange-traded equity options.
- Cash settlement - Cash-settled options do not require the actual delivery of the underlier. Instead, the corresponding cash value of the underlier is netted against the strike amount and the difference is paid to the owner of the option. Examples of cash-settled contracts include most U.S.-listed exchange-traded index options.
Exercise Considerations
The following guidelines determine whether and when to exercise an option:- An option should only be exercised if it is in-the-money by at least as much as the fees for the underlying transaction.
- In most cases, options should not be exercised before expiration because doing so gives away inherent value, in the same way that surrendering a fully paid insurance contract before maturity gives away value.
- For an American-style call option, early exercise is a consideration whenever the benefits of being long the underlier outweigh the costs of surrendering the option early. For instance, on the day before an ex-dividend date, it may make sense to exercise an equity call option early in order to collect the dividend. In general, equity call options should only be exercised early on the day before an ex-dividend date, and then only for deep in-the-moneyMoneynessIn finance, moneyness is a measure of the degree to which a derivative is likely to have positive monetary value at its expiration, in the risk-neutral measure. It can be measured in percentage probability, or in standard deviations....
options. - For an American-style put option, early exercise is a consideration for deep in-the-money options. In this case, it can make sense to exercise early to be short the stock, and therefore collect short interest from the short stock position. In general, this makes most sense for underliers that don't pay dividends, and are not difficult to borrow. Ex-dividend dates are generally not a concern for determining when to exercise a put option early.
Early Exercise Strategy
A common strategy among professional option traders is to sell large quantities of in-the-moneyMoneyness
In finance, moneyness is a measure of the degree to which a derivative is likely to have positive monetary value at its expiration, in the risk-neutral measure. It can be measured in percentage probability, or in standard deviations....
calls just prior to an ex-dividend date. Quite often, non-professional option traders may not understand the benefit of exercising a call option early, and therefore may unintentionally forego the value of the dividend. The professional trader may only be 'assigned' on a portion of the calls, and therefore profits by receiving a dividend on the stock used to hedge the calls that are not exercised.
Assignment and Clearing
Assignment occurs when an option holder exercises his option by notifying his broker, who then notifies the Options Clearing CorporationOptions Clearing Corporation
Options Clearing Corporation or OCC, founded in 1973, is the world's largest equity derivatives clearing organization, providing central counterparty clearing and settlement services to 14 exchanges and platforms for options, financial and commodity futures, security futures and securities...
(OCC). The OCC fulfills the contract, then selects, randomly, a member firm who was short the same option contract. The OCC then notifies the firm. The firm then carries out its obligation, and then selects a customer, either randomly, first-in, first-out, or some other equitable method who was short the option, for assignment. That customer is assigned the exercise requiring him to fulfill the obligation that he agreed to when he wrote the option.