Exercising an options contract

Factual Questions
1

Do not need questions fast and it may depend on the broker (or maybe not).
This is a rare situation as people will buy/sell their option contracts before the option expires OR they do want to take delivery of the stock (call) or sell the stock (put) if in the money [which is rare] If your option expires in the money, your broker will exercise it for you but I’m not exactly sure what the end result is.

Scenario: Option on ABC stock, $50 call, 1 contract. When the contract expires, ABC is at $55. Will the broker:

  1. Exercise the contract for me buying the 100 shares for me (out of the broker’s funds I guess) then immediately sell them for the $55 and put the $5 difference x 100 shares = $500 in my account.
  2. Do the exact same thing but in the opposite order so they don’t put any money out, viz. short the stock at $55 and cover at $50 via my options contract resulting in net $5 difference x 100 shares = $500 in my account.
  3. Buy the 100 shares @ $50 and take $5000 out of my cash. If I don’t have $5000 I’d better figure out how to get it during the T+3 period. Probably by selling the stock the next business day.
2

That depends on whether the contract of the option provides for physical settlement or cash settlement. Physical settlement means the transfer of the underlying at the option price is actually carried out; cash settlement means the price difference is paid but no actual delivery takes place. Both clauses exist, it’s a matter of what the contract says. FWIW, large institutional investors that deal a lot in options will usually clear their options contract via a central counterparty that maintains a current margin account for all its clients where the losses and profits from the many options transactions are booked on an ongoing basis. As a private retail investor, you’ll typically trade options in the form of warrants, which are standardised tradeable securities, and these are overwhelmingly cash-settled.

3

How would I check that on my broker’s site?

4

It’s not a question of the broker, it’s a question of the contract of the option. If it’s a warrant, it’s a tradeable security, so that is governed by the prospectus. If it’s an options contract, then it will, in the vast majority of cases, be a standardised one based on pre-defined standard terms and conditions, which will govern the issue.

5

It does depend on the broker. Here is an example account agreement from Etrade, which I think is pretty typical. The agreement says in relevant parts:

E*TRADE has no obligation to exercise any option absent specific instructions from the Account Holder.

So, Etrade says they aren’t required to exercise your options for you if you don’t give them specific instructions to do so on time. You can issue standing instructions to your broker to exercise all in-the-money options contracts on the expiration date for you. But, ETrade also says they can exercise the option for you, even without your instructions, if they choose to do so. To whit:

If the Account Holder has not provided any instructions to ETRADE in accordance with the previous paragraph and they own options that are about to expire “in the money,” ETRADE may, at its sole discretion and without notice to the Account Holder, exercise the option. If such an exercise would require the purchase or sale of the underlying security for which the Account Holder does not have sufficient funds or securities available, ETRADE may, at its sole discretion and without notice to the Account Holder, enter offsetting transactions to close out the position. Although ETRADE has the discretion to take such action, ETRADE is not obligated to do so. In the event that ETRADE exercises an in-the-money options contract for the Account, and in the absence of instructions from the Account Holder, E*TRADE may thereafter close out any resulting positions (e.g., buy-in short positions or sell long positions).

If the option settles in cash, it will automatically be exercised for you and you will just get cash for the difference between the strike price and the closing price of the stock. Most (or possibly all) listed single-stock options in the US are “physically settled,” meaning that shares are delivered as necessary.

If your option is physically settled and if you already have cash in the account to cover the purchase, your ETrade will just buy the stock for you. It’s up to you to choose how long to hold it and when to sell it. You will bear all the risk like any other stockholder.

If you don’t have the cash in your account, ETrade can enter offsetting transactions (and, as a practical matter, they will). That is, they will sell the underlying stock. From your perspective, the option purchase and the stock sale will happen simultaneously. ETrade doesn’t say it in their agreement but there are special market orders that are executed at the closing price. ETrade will likely use one of those orders to sell your shares at the market close price. Thus, when they exercise your option on your behalf, they will already have ordered the sale of the underlying shares. The stock transaction settles the business day after the transaction (T+1) and the option transaction settles two days after exercise (T+2), but when both have settled, you will just have cash in your account reflecting the difference in price between the strike price of the option and the sale price (less any brokerage fees).

In theory, (3) could happen because ETrade could opt to both exercise the option on your behalf but opt not to enter into an offsetting transaction. However, the ordinary processes at any competent broker-dealer won’t let that happen. Perhaps this could happen in times of extraordinary weirdness.

ETA: Added link to account agreement.

6

Sure, if you wish to exercise the option you need to instruct your broker to do so - at least in “American-style options”, where the option can be exercised at any time prior to expiry; this you need to tell your broker since the choice if and when to exercise is yours. By contrast, the “European-style option” can be exercised only at the time of expiry; widespread practice here is that at this time the broker calculates if the option is in the money, and if it is, will automatically exercise it for you.

Either way, the question whether the option is physically or cash settled is not between you and the broker; this is defined by the option contract, which, in the case of warrants, is embodied in the prospectus. This is independent of which broker you use for trading.

7

So when I pull up the contract in my broker’s website, will the information if the contract is physically or cash settled. TD Ameritrade if it matters.

8

Not entirely true. ETrade (and most other brokers, which have similar customer account agreements) can choose to exercise the option for you even without your instructions. If you give ETrade specific instructions about exercise, they can’t contradict them but, if you don’t give them specific instructions, they generally give themselves the right, but not the obligation, to exercise on your behalf when it is in your interest to do so.

Brokers will generally exercise your in-the-money options for you regardless of the style of option. But the brokers don’t generally obligate themselves to exercise on your behalf unless you tell them to do so. I don’t see that the account agreements treat American versus European-style options differently in this regard so the distinction you draw is not particularly relevant.

This is true and nothing I said indicated otherwise.

9

I don’t think this is true. Suppose I have a European-style option that expires half a year from today. Suppose further that it is in the money, but I expect it to get more deeply into the money over the next six months. If my broker now exercised the option without instruction from me, I would deprive of the opportunity to make a larger gain than I get now. I agree with you that a broker would surely not do so against my explicit instruction not to exercise; but I doubt a broker would do so if I remain silent, instructing neither to exercise nor not to. I do admit that I haven’t checked terms of conditions of brokerage firms in this regard; I would simply regard it as odd if a brokerage firm assumed for itself the right (though not obligation) to exercise a European-style option at any time it is in the money. For American-style option the issue doesn’t arise, because such options can only be exercised at one moment in time, and it can be objectively ascertained at that moment whether exercise is in the client’s interest or not; so there is no need for an instruction here. But in the case of a European option the question whether it is in the client’s interest to exercise depends on the client’s expectations of future market developments.

Well, you did say “It does depend on the broker”, and I assumed that the “It” in that sentence refers to the question whether the option is physically settled or cash settled. I made that assumption because you wrote it in direct response to a post of mine in which I was saying that this issue is governed by the terms of the option, not the terms of the brokerage firm. If that assumption was wrong, then there is indeed no disagreement on this point.

10

You have American and European backwards here. And your broker would only exercise (or sell) and in-the-money American option just before it expires – never before unless there were some kind of margining problem. I don’t see how that would happen though as you can’t margin options.

11

I said regardless of the style of option, not regardless of all the circumstances of the option. No, they will not exercise your option on your behalf if it still has lots of time value or money left. I said they would do it when it is in your best interest, that is, when it is about to expire in the money and you have not given them instructions about whether to exercise it.

Also, as @OldGuy noted, you have European and US-style options reversed.

I was not responding to your post; I was responding to the OP. It’s hard to distinguish on this system sometimes.

Wait, somehow I missed your earlier post.

The Options Clearing Corp. is the central clearing party to which you are seemingly referring. Its members are mostly registered broker-dealers. Most other traders, large institutions included, don’t directly interact with them. They clear however their broker clears for them. Their broker will clear through the OCC.

The OCC does not extend margin on behalf of its members. Quite the opposite, the OCC requires each member to have more capital on deposit than is necessary to satisfy the member’s obligations to OCC. The excess funds on deposit are used to make sure that even if one or some members fail, the OCC will be able to use the excess funds on deposit from other members to make investors whole. In the event that’s not sufficient, the OCC can require members to deposit even more money.

Most individual investors trade exchange-listed options, not warrants. Exchange-listed options are standardized contracts but they are not generally warrants. They are overwhelmingly physically settled, in the case of single-stock options (which was the OP’s example). Warrants are usually issued by the companies themselves, and they are usually physically settled too. Exchange-listed options on securities indexes are usually cash settled but the OP’s question wasn’t about index options.

12

Always nice to find a question I can give a good FQ answer to, I’ve worked on options trade desks and have been the person behind making those decisions.

This will depend on individual firms and even at individual firms, their policies may change.

The most likely response to you holding a $50 long call in your account without the cash available to exercise it, is for the brokerage firm selling to close your $50 call for about $5.

  1. This happens very rarely. I’ve only seen it happen when an account slipped though the risk reports, often someone opened a position right at the end of the day. In that case, the risk group might place an order to offset the position in that Friday after hours session.

  2. A firm wouldn’t go short, they’d just place an order to sell the stock that will result from the auto exercise. In the above example, they’d be trying to sell the ABC for around the $55 market price in the after hours session.

  3. This definitely happens and it’s now T + 2 for stock settlement. Options in a self directed account definitely require constant maintenance. Different firms will handle risk in different ways. Allowing your $50 ABC call to expire in the money can definitely hurt you if you’re not expecting it and ready to take action.