Exercise Options – Key Points About Selling Options Part 10
Exercise Options – Key Points About Selling Options (Part 10)
This final section here is a bit more simplistic, but some interesting background with respect to exercise and assignment rights and obligations. I already said most contracts are closed before they ever reach expiration, but sometimes they actually do get till expiration. So, what happens if that is the case. Well, the buyer has paid for the right to exercise the contract at their discretion. That’s what they paid for. In order to do that, they need to proactively notify their brokerage firm that they want to exercise the contract.
Now there has to be some kind of a default process that the industry takes on if the buyer doesn’t communicate any instructions at all. And that is known as Auto X, that’s sort of a shorthand term. It’s actually called exercise by exception. The industry will compare the strike price of the option to the last traded price of the underlying stock in regular trading hours on expiration day, compare those two numbers, and determine the moneyness status of the option. If it’s ‘in the money’, then it will be exercised on the buyer’s behalf. Even if they haven’t told their brokerage firm do so, it will happen. If the option is determined to be ‘at the money’ or ‘out of the money’, then it is abandoned and that will happen whether the buyer communicates anything or not. So that’s something buyers need to be aware of. Quick example, investor buys a March $80 strike call option and pay a dollar and a half.
Now the stock has rallied, it’s gone up from $79 up to $84, this investor decided not to buy stock. They bought the option instead, there were reasons for that. But, maybe now the reasons have changed, and this investor thought well, it’s going to go one way or another it’s taken off to the upside. It’s moved a decent amount, seven or eight percent, and now they want the shares. They don’t want to get out of this position and that would be the motivation to go ahead and say, I’m going to pony up the cash and buy shares now because it’s already moved in my favor, so I want them. Taking delivery of 100 shares paying the strike price of 8400 leaves this investor with an open position of long 100 shares and an unrealized profit with a cost basis of $81.50.
Like I said before, most options investors will trade out of the position before getting to exercise. In our case, this option ends up four dollars ‘in the money’. So, the holder of this is going to try to sell it for four dollars and they probably can’t. The bid-ask spread is probably going to be, who knows what it’ll be, $3.90 $4.10 or something like that. But, most likely this investor going to have to sell their option for a little bit under $4. Just a bit of a note on that, when you see wider bid-ask spreads it largely has to do with the stock bid-ask spread itself. Professionals who are market makers have to hedge their position. They don’t want to take on any Delta’s, so if they’re going to purchase this option from you for trying to sell it then they are going to have to offset that long Delta position by selling stock. They’ll look at the bid on the stock and how much there is on the bid side and that spread on the actual shares between the bid and offer will dictate to a large extent the bid-ask spread on the options contract.