Exercise, assignment and expiration day

An option ends in one of three ways: it is closed in the market, it is exercised, or it expires worthless. Holders exercise only about 7% of options, according to the Options Industry Council. When they do, the rules below decide who buys shares, who delivers them, and when.

What exercising an option means

To exercise an option is to use the right it contains. The holder of a call buys 100 shares per contract at the strike price. The holder of a put sells 100 shares per contract at the strike price.

The holder gives the instruction to the broker, and the broker passes it to the Options Clearing Corporation. Options on stocks and on exchange-traded funds are American-style: the holder can exercise on any business day until the option expires.

An exercise uses up the option. Whatever time value the option still had is lost, which is why a holder who wants to take a gain before expiration usually sells the option.

What assignment means for the writer of an option

For every holder who exercises, a writer of the same option is assigned. The Options Clearing Corporation assigns the exercise by a random procedure to a brokerage firm whose customers have written that option. The firm passes it to one of those customers, usually at random or first in, first out.

The writer who is assigned must fulfil the contract. The writer of a call delivers 100 shares per contract at the strike price, and the writer of a put buys them. Assignments are determined after the market has closed, from the positions that are open at the end of the day. A writer who bought the option back during the day can no longer be assigned, and a writer who was assigned can no longer buy it back.

What happens on the expiration day of an option

Standard monthly options on stocks expire on the third Friday of the month, and weekly options in most cases on the Friday of their week. An expiring option trades until the market closes on that day, at 4:00 p.m. Eastern Time. After the close its fate is decided by where the stock ended.

The procedure is known as automatic exercise. Its name in the rules is exercise by exception, and it is not automatic in the strict sense, because the holder always has the choice. A broker may also apply a threshold of its own.

Holders have until 5:30 p.m. Eastern Time on the expiration day to give their instructions, and brokers set earlier deadlines for their customers. A holder who does not want the shares, or does not have the money for them, has to sell the option before the close or give the instruction in time.

How the exercise of an option is settled

Options on stocks are settled by delivery, called physical settlement. Shares and cash change hands: 100 shares per contract against the strike price times 100. Since 28 May 2024 the delivery settles on the first business day after the exercise.

Why an option is exercised before its expiration date

An early exercise gives up the time value of the option, so it makes sense for the holder only when that time value is small against what the exercise brings.

The common case is a call in the money on the day before the stock goes ex-dividend. The holder of a call does not receive the dividend. By exercising on the day before, the holder owns the shares in time to receive it. It pays when the dividend is larger than the time value that is given up.

The other case is a put deep in the money. Its holder can exercise to receive the strike price now and not later, and professional traders usually do.

For the writer, each of these cases is an early assignment. The writer of a call who is assigned before the ex-dividend date delivers the shares and does not receive the dividend.

What can go wrong at exercise, assignment and expiration

An exercise nobody intended. An option that ends $0.01 in the money is exercised automatically. A holder of five calls with a strike price of $180 who forgets them on the expiration day buys 500 shares for $90,000.

A stock that ends at the strike price. When the stock closes at or very near the strike price, a writer cannot know until the Monday after expiration whether the option was assigned. This is called pin risk. The stock can open at a different price on Monday, and the writer holds shares, or lacks them, without having planned for it.

A move after the close. Holders can still give instructions until 5:30 p.m. Eastern Time. A move of the stock in that time can lead holders to exercise options that closed out of the money, so the risk of assignment does not end with the trading day.

A halt in trading. When trading in a stock is halted, trading in its options is halted too. Holders can usually still exercise during a halt, and the writer of a put who is assigned must buy the shares whether they trade or not.