Every now and then it’s wise to review some of the basic elements in the options working method. Today I am going to review what happens when an-in-the-money option turns into the underlying asset, long or short (i.e., bought or sold,) through exercise and assignment.
This happens in two ways, depending on the style of option. American-style options may be exercised at any point in their lifetime and results in the physical delivery of the underlying asset. Individual stock options are American style.
European-style options may not be exercised before expiration and are settled in cash. As a rule, index options are European style.
Let’s first examine cash settlement (European-style options), as people new to trading sometimes find it confusing. The option settles in cash at the difference between the exercise price and the index at expiration. Let’s take a hypothetical index which trades at 110 the moment the option expires. This creates a settlement price of 110. So, the owner of the 100 call receives $10 in cash, regardless of what the owner paid for the option. The person who is short the 110 call at expiration pays $10, regardless of the original sale price. The owner of the 110 put and below gets nothing. The owner of the 120 put gets $10, the owner of the 120 call and higher gets nothing, and so on.
This differs from American-style options which result in the physical delivery of the underlying asset. So, if I buy the IBM 100 call I can turn that option into 100 shares of IBM at a price of 100 regardless of how much time there is to expiration. If I buy the 100 put I can sell IBM at 100 regardless of how much time is left.
Let’s say I own 1000 shares of IBM and I own 10 IBM puts with an exercise (also known as strike) price of 250. I decide it’s not worth carrying this stock any longer and I wish to “put” the shares away. I send an exercise notice to the exchange and the exchange randomly assigns my options, one at a time, to anyone who is short (has sold) that option.
An important point to remember is that the person assigned on my option (who therefore has to take delivery of IBM at 250,) is not necessarily the person who sold them to me in the first place. The assignment process is entirely random.
There are sound reasons to exercise in-the-money stock (American style) options early, but that is a topic for another column.
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