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:
http://www.ParkwoodCapitalLLC.com

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