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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. 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 account is credited with $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

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