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.
Exercise Type
The option style determines when, how, and under what circumstances, the option holder may exercise.
- European - European-style option contracts may only be exercised at the option's expiration 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-money 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-money 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 Corporation (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.
References
- ^ (PDF) Characteristics and Risks of Standardized Options . Options Clearing Corporation . http://www.theocc.com/publications/risks/riskstoc.pdf . Retrieved 2007-06-21 .
- ^ John C. Hull (2002). Options, Futures and Other Derivatives, 5th edition . Prentice Hall. p. 744. ISBN 0-13-009056-5.
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