When you first trade options, it can seem like you’ll need to somehow connect with the buyer or seller on the other end of the option contract when the option expires. This can be a particular concern when the underlying security is trading “near the money”.
Do stock options automatically exercise so you, as the option buyer or seller, don’t have to worry about options on the expiration date? Whether or not an option is automatically exercised depends on the option’s strike price relative to the market price of the underlying stock (or ETF) at option expiration. If an option expires “in the money”, the option exercise will be completely automated through a clearing house called the Options Clearing Corporation.
An Example of An Option Being Exercised Automatically
To demonstrate the automatic exercise of an in the money option, let’s say you sell a call option as part of a simple covered call strategy.
In this example, you own 500 shares of Profit, Inc for the underlying stock. Your stock cost is $100 a share so you sell 5 call options with a $105 strike expiring on September 22 of that same year.
Each option contract represents 100 shares of stock, hence the 5 option contracts.
In this example, let’s say the stock price rises to $107 at the market close on option expiration day.
The option buyer will, of course, want to exercise the call option since he can buy the stock at $2 less than the market value of $107. This will force you, the option seller, to sell your shares to the call option buyer at the option strike of $105.
Neither the option seller nor the option buyer, however, need to do anything at option expiration.
- The option will automatically expire and be exercised.
- The option buyer will automatically buy 500 shares of the stock at a cost of $105 per share.
- The option seller will automatically sell 500 shares of stock for $105.
How Is the Option Automatically Exercised?
The option buyer’s broker connects with the option seller’s broker through the clearing house.
The Option Clearing Corporation (OCC) has the role of automatically exercising an in the money option at the option’s expiration date.
In the United States, monthly options expire on the third Friday of every month. Weekly options expire every Friday.
Technically, options expire on Saturday, but since the markets are closed on Saturday’s, options are thought of as expiring and getting exercised on Friday.
Can an Out of the Money Option Be Exercised Automatically?
There are set rules the Options Clearing Corporation must follow about when to exercise an option contract. Any equity or index call or put option $.01 or more in the money at option expiration will be exercised automatically by the OCC.
When an option contract trades very close to the option strike price on option expiration day, it can be tricky knowing if an option will expire in the money or out of the money, thereby triggering the 1 cent in the money automatic option exercise rule.
For this reason, many option sellers choose to buy back option contracts near option expiration. A covered call writer, for example, may buy back call options about to expire and subsequently sell a call option with an expiration date a month or more out. In this case, a higher option premium will be received by the option seller because more time value is built into the price of the option being sold than the option being bought back.
Since an option has no time value left at option expiration, the covered call writer can buy the unpredictable near the money call back very close to intrinsic value. Intrinsic value is the difference between the option strike price and the stock’s market price.
The good thing is that the option seller has a choice whether to buy back the call option, rather than risk the call option being automatically exercised when the strike price and the market price are very close on option expiration day.
If you’re an option trader, don’t worry; you can take it easy on Friday afternoons. The OCC will automatically exercise your options should they expire in the money.
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