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Exercising
an Option
In
most cases stock options are bought and sold for the purposes of
speculating -- holders will rarely choose to exercise and writers
usually will not risk the possibility of being assigned because
this process involves the handling of the underlying security. In these cases buyers and writers will close trades in the
open market prior to expiration.
If
the holder of an option does exercise his right to buy (in the
case of calls) or sell (in the case of puts) the underlying
security as per the parameters of the contract a dynamic process
begins.
First,
the holder must direct his broker to submit an exercise notice to
the Options Clear Corporation (OCC). This notice directs the OCC to begin the process of
matching the request with an option writer. The OCC contacts its member firms to determine what firms
have clients with short positions in the corresponding option and
these member firms are given assignment notices.
Once
the member firm has been given the assignment notice that firm
will assign customer accounts with short positions in the assigned
option contract. If
the option is deep in-the-money at expiration the odds are good
virtually all accounts with short positions with be assigned. The customer is obligated to sell (in the case of calls) or
buy (in the case of puts) the underlying security at the specified
strike price. Arrangements
are then made with the OCC, member firm and the member designated
Clearing Corporation to have the shares delivered to the buyer.
If
the writer cannot make physical delivery of the underlying common
stock the member firm will create a debit in the customer account.
Consider
this example. A
customer writes one contract of the IBM Corp. November 100 calls
at $2 when the common stock is trading at $100 and receives $200. The stock rallies to $110 by the November option
expiration. The
customer is given a notice of assessment to deliver 100 shares of
IBM Corp. at $100 but these shares are not found in the customer
account. The
brokerage firm creates a debit in the customer account for 100 shares of IBM Corp. and the
customer's account is credited with $10,000 (100 shares of IBM
times $100) as per the contract. The
shares are delivered to the OCC.
This
transaction creates a short position in the customer account and
it is now his responsibility to cover that position. Brokerage firms are usually very careful to make certain
that clients that write options that are uncovered by stock
positions held in their account have adequate margin.
strike
price 
benefits of
options
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to Options > Exercising an
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