4.3.3 The exercise process
If you’ve ever wondered what happens “behind the scenes” when an option is exercised, this is the chapter for you! Test questions may ask a few questions on the logistics. To understand the process, let’s work through a scenario:
An investor is long 1 ABC Jan $50 put. ABC’s market price declines to $45, and the investor exercises the put.
The $50 put is “in the money” by $5, so it makes sense to exercise the option. The investor must contact their broker-dealer in some manner (electronically, via phone call, or in person) to submit exercise instructions.
When the firm receives the exercise notice, it will notify the Options Clearing Corporation (OCC). The OCC’s role is to assign the contract fairly. The investor is long a $50 put, and there are potentially thousands of investors short that same $50 put contract. The OCC will assign one of those investors the exercise notice by utilizing a list of member firms with customers short the $50 put. The list could even include the firm that submitted the exercise notice, which would occur if the firm had other customers who wrote the same contract.
Using a computer randomizer, the OCC assigns the contract to one of the firms with customers short the $50 put. This process ensures the assignment is fair by picking a firm on a random basis. Remember, writers (investors with short options) want to avoid being assigned (exercised)! The best-case scenario for a writer is expiration.
A firm that is randomly chosen for assignment may have one or more customers short the $50 put. If it’s just one customer, it’s pretty simple! They assign that customer, forcing them to buy 100 ABC shares at $50. If the firm has multiple customers short the $50 put, it can select the customer it assigns on a FIFO (first in, first out) basis*, random basis, or any other fair method. Using one of these methods, the firm will assign a specific customer, forcing them to fulfill their obligation to buy 100 shares at $50.
*A FIFO basis would select the customer that wrote the contract the earliest.
Once the writer is assigned, both parties have one business day to fulfill their end of the contract. The put holder (with the right to sell) must deliver 100 ABC shares, while the put writer (with the obligation to buy) must deliver $5,000 cash ($50 x 100 shares). Both actions must be completed by T+1 (the first business day after the exercise).
Option exercise process
There are a few notable cutoff times related to exercising an option on the expiration date. First, 4:00 p.m. ET is the cutoff time to trade a contract. Once the market closes, no more trades can occur. Holders have 90 minutes from the market close to submit exercise instructions. Therefore, the broker-dealer must receive exercise notices by 5:30 p.m. ET on expiration Friday. If unexercised, the contract officially expires at 11:59 p.m. ET.
Another item to consider is automatic exercise. If the contract is “in the money” by a penny ($0.01) or more on the expiration date, it is automatically exercised by the broker-dealer. This avoids the problem of an investor forgetting to exercise a valuable option and letting it expire.
Even if a contract is in the money, some investors may not want an exercise to occur. For example, let’s assume this situation:
Long 1 BCD Feb 30 call
Market closes at $30.01 on expiration Friday
While the investor is in the money, it’s only by a penny. If they exercised the call, they could buy 100 shares for $30.00 and sell them for $30.01 in the market, locking in a $1 overall profit ($0.01 x 100 shares). If the investor is worried about risks related to the stock, a $1 profit from exercise may not be worth it. This is especially true as the weekend falls right after expiration, and a lot could happen with the stock’s price before the market opens the following week!
To avoid being automatically exercised, investors must submit contrary exercise advice (CEA). In plain terms, this is a notice to the firm not to exercise the option, regardless of its intrinsic value/“in the money” status.
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