Index Options Exercise & Assignment Explained

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Contents

Index Options: Exercise & Assignment

Index options have slightly different exercise and assignment procedures compared to equity options. Firstly, while equity options are american-styled, index options can be either american-styled or european-styled. Secondly, unlike equity options where the underlying stocks have to change hands during settlement, index options are generally cash-settled whereby only cash is required to be transferred to settle the differences.

American vs European Exercise

American style options allow the holder to exercise anytime before expiration while european style options can only be exercise during a certain predetermined exercise period, usually at the end of the option’s lifespan.

Assignment

On receiving an exercise notice, the Options Clearing Corporation (OCC) will, in accordance to established procedures, assign it to one or more Clearing Members who have short positions in the same series. In turn, the Clearing Members wil assign it to one of their customers.

Upon assignment, the index option writer has the obligation to pay the settlement amount in cash. Settlement usually occur on the next business day after the exercise.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

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Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Index Options: Exercise & Assignment

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

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Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Index Option

What is an Index Option?

An index option is a financial derivative that gives the holder the right, but not the obligation, to buy or sell the value of an underlying index, such as the Standard and Poor’s (S&P) 500, at the stated exercise price on or before the expiration date of the option. No actual stocks are bought or sold; index options are always cash-settled, and are typically European-style options.

Basics of an Index Option

Index call and put options are simple and popular tools used by investors, traders and speculators to profit on the general direction of an underlying index while putting very little capital at risk. The profit potential for long index call options is unlimited, while the risk is limited to the premium amount paid for the option, regardless of the index level at expiration. For long index put options, the risk is also limited to the premium paid, and the potential profit is capped at the index level, less the premium paid, as the index can never go below zero.

Beyond potentially profiting from general index level movements, index options can be used to diversify a portfolio when an investor is unwilling to invest directly in the index’s underlying stocks. Index options can also be used in multiple ways to hedge specific risks in a portfolio. American-style index options can be exercised at any time before the expiration date, while European-style index options can only be exercised on the expiration date.

Key Takeaways

  • Index options are options to buy or sell the value of an underlying index.
  • Index options have downside that is limited to the amount of premium paid and upside that is unlimited.

Index Option Examples

Imagine a hypothetical index called Index X, which has a level of 500. Assume an investor decides to purchase a call option on Index X with a strike price of 505. With index options, the contract has a multiplier that determines the overall price. Usually the multiplier is 100. If, for example, this 505 call option is priced at $11, the entire contract costs $1,100, or $11 x 100.

It is important to note the underlying asset in this contract is not any individual stock or set of stocks but rather the cash level of the index adjusted by the multiplier. In this example, it is $50,000, or 500 x $100. Instead of investing $50,000 in the stocks of the index, an investor can buy the option at $1,100 and utilize the remaining $48,900 elsewhere.

The risk associated with this trade is limited to $1,100. The break-even point of an index call option trade is the strike price plus the premium paid. In this example, that is 516, or 505 plus 11. At any level above 516, this particular trade becomes profitable. If the index level was 530 at expiration, the owner of this call option would exercise it and receive $2,500 in cash from the other side of the trade, or (530 – 505) x $100. Less the initial premium paid, this trade results in a profit of $1,400.

Index Option Trading

Introduced in 1981, stock index options are options whose underlying is not a single stock but an index comprising many stocks. Investors and speculators trade index options to gain exposure to the entire market or specific segments of the market with a single trading decision and often thru one transaction. Obtaining the same level of diversification using individual stocks or individual stock options require numerous transactions and consequently slower decision making and higher costs.

Leverage & Predetermined Risk for the Buyer

Like equity options, trading index options gives the investor leverage and predetermined risk. The index option buyer gains leverage as the premium paid relative to the contract value is small. Consequently, for a small percentage moves of the underlying index, the index option holder can see large percentage gains for his position. Furthermore, risk is predetermined as the most the index option trader can lose is the premium paid to hold the options.

Contract Multiplier

Stock index options typically have a contract multiplier of $100. The contract multiplier is used to compute the cash value of each index option contract.

Premium

Similar to equity options, index options premiums are quoted in dollars and cents. The price of a single equity index option contract can be determined by multiplying the quoted premium amount by the contract multiplier. This is the amount that an index option buyer will need to pay to purchase the option and the amount that the index option writer will receive when selling the option.

Rights Conferred

As index options are cash-settled options, the holder of an index option does not possess the right to purchase or sell the underlying stocks of the index but rather, he or she is entitled to demand the equivalent cash value from the option writer upon exercising his option.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Understanding Options: Exercise & Assignment

As an educator in the field of options trading, I’m often asked “what causes a short call or a short put to be assigned?” Before I can answer that question I need to briefly explain what an option is, some of the terminology used, and who the participants in the exercise and assignment process are. Lastly, this discussion pertains to the American style options. These are the type of options that most of us buy and sell. They are the type of options that you would see for most equities like Apple or American Airlines. The other style of option, which we will not be covering in this discussion, is the European style option. Those options do not provide for the buying or selling of the underlying itself. They settle at expiration in cash only.

Let’s look at the basics of exercise and assignment from a theoretical perspective. In the most basic sense, options are an agreement between two parties. That agreement provides the owner of the option the right to do something. The seller of that same option is therefore obligated to fulfill the rights of the long option holder. The buyer of a long call option is purchasing the right to acquire the underlying equity for a specific price for a certain amount of time. If it is in his or her best interest financially to exercise their right than they would do so. This is known as exercising an option.

When an investor sells that same call option, they are paid a premium which is deposited into their brokerage account. At the same time, they have an open obligation to fulfill the rights of the long call option holder. If the long call option holder decides that it is in their own best interest to exercise their rights and to buy the underlying, then the short call seller would be obligated to provide the underlying to them. This is referred to as assignment.

In the case of a put option, the investor who buys a long put is purchasing the right to sell the underlying equity for a specific value for a specific amount of time. That means that if the long put holder decides that it is in their best interest to exercise their put the short put seller would be assigned and therefore have to buy the underlying equity.

Once an options contract is opened it can be exercised 24 hours a day, seven days a week. Opening or closing an option contract is quite different than exercising one. Options are opened through an exchange (like the Chicago Board of Options Exchange). They can be closed in several different ways:

1. The option can simply expire worthless at expiration
2. It can be closed by placing an order with the brokerage which is sent to one of the member exchanges
3. It can be exercised which would trigger the assignment process which would also close the option

In the first scenario above if the option is out of the money and options expiration, it would simply cease to exist and would be removed from your portfolio.

In the second scenario, you would actively send in order through your brokerage which would be routed to one of the member exchanges to close it.

The parties that are involved in the exercise and assignment process go beyond your brokerage.

In the third scenario, the long option holder is simply exercising their rights and therefore does not need an exchange. So who does the actual administrative functions to exercise and assign an option? That task would be carried out by the Options Clearing Corporation (OCC). Here’s a little bit of information about the OCC: All of the options exchanges (CBOE, Philly Exchange, Pacific exchange, etc.) are charter members of the OCC. The OCC creates the rules and bylaws that regulate and control the buying and selling of options as well as the assignment and exercise process. The member exchanges can be thought of as simply a marketplace where buyers and sellers are brought together to open a contract or to close a contract. The exchanges have no role in the actual rights and obligations of the options instrument. That process belongs to the OCC.

When a long option owner decides to exercise their rights, they would tell their broker to do so. Since we’re not talking about negotiating to open or close a contract but rather simply exercising the rights of the contract, there is no need for a marketplace or exchange so the order goes directly to the OCC. Once the OCC has the exercise order they randomly select a brokerage who is short that same option. The OCC then sends a notice of assignment to the brokerage. The brokerage in turn, selects one of their accounts at random and assigns them the obligation.

So when exactly do options get assigned? Options assignment can occur at any time once an options contract is opened. At options expiration if an option is in the money by as little as one cent, it will be exercised; with one minor caveat. That caveat is OCC rule 805D and is beyond the scope of this particular discussion. A complete list of the OCC rules can be found here: http://www.optionsclearing.com/components/docs/legal/rules_and_bylaws/occ_rules.pdf

American-style options can be exercised at any time, 24 hours a day seven days a week until they reach their expiration. So what would cause your short option to be assigned early?

It is rare that a short option that is in the money is assigned early, but it does happen occasionally. The most common cause of early assignment pertains to a short call of an equity that is about to go ex-dividend. Keep in mind that the only reason someone would exercise their long call (other than by mistake), would be if it was in their financial best interest to do so. So, in the case of a dividend paying equities, if the dividend itself is greater than the remaining extrinsic value of the in the money call option, it would make sense for the long call folder to exercise their long call, by the stock and capture the dividend. They would forfeit any remaining value in their long call. However, as I indicated above, if the dividend is greater than the remaining extrinsic value of their option, it is in their best interest to exercise their long call.

Short puts do not generally get assigned early. Keep in mind that it requires an active exercise by the long put holder to trigger the exercise and assignment process. While it can happen prior to expiration, it typically does not.

I hope that this brief explanation of the exercise and assignment process helps to clarify your understanding of how options actually work. They are contracts, legal financial contracts with performance rights and performance obligations. Please make sure that you understand your rights and your obligations before entering any trade.

Jeff McAllister
OptionsANIMAL VP of Education

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