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Option Expiration and Exercise

By Kerry Given

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Published: 02Jul2009
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Beginning options traders often make costly mistakes due to either a lack of knowledge or misinformation about the basic parameters of options and their exercise. Examples of common errors include being surprised that one is unable to close an index option position on the Friday before expiration, or being surprised by an unhedged option exercise during expiration. This paper covers some of the basic concepts surrounding option expiration and how options are exercised. Be sure you understand the settlement, exercise, and expiration characteristics of the options you trade.

Option Expiration

Equity options expire on the Saturday following the third Friday of each month. It is common to hear or read that equity options expire on that third Friday. While that isn't technically correct, it is true that Friday is the last opportunity to trade those options. Saturday expiration was established to give the brokerages time to settle the accounts before the options technically (legally) lose their value.

However, some (but not all) index options cease trading at the close on the Thursday prior to expiration and those positions are reconciled on Saturday based upon the settlement price established on Friday. For example, the SPX index options cannot be traded after the close on the Thursday before expiration; but the settlement price, usually reported as SET or $SET, is established Friday morning based on the opening price of each of the 500 S&P stocks. Since many stocks do not open immediately at the opening bell, the settlement price will differ from the SPX opening price on Friday.

Option Exercise

The owner of an equity option has the right to buy or sell 100 shares of the underlying stock anytime before expiration. If you are long the option (i.e., you originally bought it), you may or may not choose to exercise the option you own; it is entirely your choice. If you are short the option (i.e., you originally sold the option), it may be exercised against you at any time. Typically, you will receive an email from your broker after the market close, notifying you of the exercise. You may be exercised for only a portion of your option position, e.g., only 2 of your 10 contracts. If you were short call options, you will now see a short stock position in your account, i.e., you were obligated to sell the stock at the strike price. If you were short put options, the exercise forces you to buy stock at the strike price, resulting in a long stock position in your account.

When options contracts are first created, exercise is specified in one of two different ways: American style or European style. American style options can be exercised on any business day prior to expiration, whereas European style options can only be exercised at expiration. All equity options are subject to exercise American style, while most index options are European style, e.g., the SPX. But there are some exceptions with a small number of index options settling American style, e.g., the OEX.

Upon expiration, your broker will automatically exercise any expiring options in your account that are $0.05 or more ITM (in the money) in accordance with Options Clearing Corporation regulations. If expiration is approaching and the stock price is near your strike price, and you do not want to hold either the long or short stock position that will result from the exercise of your long option, sell the option before the market closes on the Friday of expiration week. If you are holding a European style index option position and wish to close it before expiration, be sure to complete those orders before the market closes on Thursday before expiration. If you wish to exercise any of your long equity options, you must issue an order to your broker before the market closes on the Friday of expiration week. It is generally good practice to close option positions before expiration to avoid unpleasant surprises.

Option spread positions always have a short option position by definition, so they are subject to exercise at any time. However, the long option protects you in this situation, e.g., if I am holding a 10 contract spread and I receive a notice of exercise from my broker for 3 of the short options, I simply ask my broker to exercise 3 of my long options to cover the exercise.

In practice, it is rare that your short option positions will be exercised against you before expiration. But, as noted above, your long option position protects you against this exercise. In general, put options are rarely exercised unless there is less than $0.10 of time value left in the option. The same is true of call options with one major exception: calls are often exercised just before a stock goes ex-dividend, e.g., if the call has $0.10 of time value remaining, but the dividend is $0.50 per share, it may be advantageous to the option owner to exercise the option and hold the stock through the ex-dividend date to collect the dividend payment. Sometimes an option will be exercised against you in a situation where it makes no sense whatsoever and is probably a mistake or due to inexperience of the person on the other side of the trade.

If you are holding a vertical spread position going into expiration, there are several different situations possible. If both of the options are fully in the money, your broker will automatically exercise both of the long and short options and credit your account with the spread amount less commissions. However, if the stock price closes expiration Friday within the spread, the situation is a little tricky and the results may surprise you. For example, if we were holding a bull call spread, the short OTM call will expire worthless and the broker will exercise the long call on your behalf, resulting in shares of stock in your account the following Monday (and perhaps a call from your broker if your account does not have sufficient cash to buy the stock). If you do not want to purchase the stock, you should close the spread before the market close on the Friday of expiration week.

Credit spreads can also result in surprises at expiration. For example, if I hold a bull put spread and the underlying stock closes Friday of expiration week at a price within the spread, my short put options will be exercised against me, resulting in a long stock position in my account. The long put option does not protect me because it expired worthless.

In general, if the stock price closes on expiration Friday within the strike prices of my vertical spread, it will result in either a long stock position or a short stock position in my account the following Monday. Unless you are willing to hold that stock position, it is usually best to close the spread on Friday. Many traders adopt a general rule of closing all option positions the week before expiration to avoid the surprises that are all too common the week of expiration.

Kerry W. Given, Ph.D., aka Dr. Duke, has over twenty years of experience investing in the stock market and over seven years experience trading equity and index options. He has taken many classes on investing and trading through the years and has discovered first hand how difficult it can be to separate the financial facts from the marketing hype, myths, and get rich quick schemes. He can be reached at: www.ParkwoodCapitalLLC.com

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