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Will My Broker Automatically Exercise Options That Expire In-The-Money?

We write a covered call or sell a cash-secured put. At expiration, the strike price is in-the-money. For calls that means lower then current market value and for puts it means higher than current market value. To demonstrate the moneyness of these strikes, let’s look at an options chain for Align technology (ALGN), a stock on our Premium Stock List as of 5/22/2016:

option chains for covered call writing

ALGN: Calls and Puts

The in-the-money call options are highlighted by the yellow field in the bid column on the left side of the screenshot while the in-the-money put options are highlighted by the purple field in the bid column on the right side of the screenshot.

 

Broker procedures for an expiring in-the-money strike

Each brokerage firm has a procedure outlined in its account agreement forms. Retail investors should be familiar with these procedures. The option owner can always submit instructions to their broker regarding whether to exercise as a customer may decide not to exercise an in-the-money option in some situations. The broker will have a threshold imposed for automatically exercising customer orders. The Options Clearing Corporation (OCC) uses the $.01 threshold for customer orders, but our firm may have a different threshold. Here are two procedural terms we should be familiar with:

 

Exercise by exception

Exercise by exception is an administrative procedure used by OCC to expedite the exercise of expiring options by clearing members. The OCC exercises options that are in-the-money by specified threshold amounts (usually ($0.01 or more in-the-money) unless the clearing member submits instructions not to exercise these options. Exercise by exception is a procedural convenience extended to OCC clearing members, which relieves them of the inconvenience of entering individual exercise instructions for every option contract. This procedure is not intended to prevent customers from communicating exercise instructions to their brokers.

Exercise by exception is the price of the regular-hours trade reported last to the OCC at or before 4:01:30 pm ET on the day before expiration. This trade will have occurred during normal trading hours, i.e., before 4:00 pm. It can be any size and come from any participating exchange. The OCC reports this price tentatively at 4:15 pm, but, to allow time for exchanges to correct errors the OCC does not make the price official until 5:30 pm.

 

Exercise thresholds

Expiring options subject to exercise by exception use the following thresholds to trigger exercise:

  • Stock and ETF options: $.01 per contract in-the-money in the customer account; $.01 per contract in-the-money in firm and market maker accounts. Index options: $.01 per contract in-the-money in all account types
  • The difference between the exercise price and the “closing price” of the underlying security determine whether expiring options are in-the-money or not

 

What is automatic exercise?

Individuals sometimes incorrectly refer to the exercise by exception procedure for expiring options as automatic exercise. The distinction is that exercise by exception always allows an OCC clearing member to make a choice not to exercise an option that is in-the-money by the exercise threshold amount or more. The exercise threshold amounts used in exercise by exception triggers automatic exercise only in the absence of contrary instructions from the clearing member. Because the right of choice is always involved in exercise by exception, exercise under these procedures is not necessarily automatic.

***It is important for us the know the exercise threshold used by our brokers and to communicate any specific instructions we may want outside these threshold specifications.

Most options traders don’t exercise options in order to take profit. According to the OCC, for the year of 2008, 69.4% of all options were closed out before they expire. This means that 69.4% of options traders simply sell their options in order to take profit or cut loss. Only 11.6% of all options contracts were exercised with only 19% of all options contracts expiring worthless. Of course this statistic totally busted the myth that more than 80% of all options contracts expire worthless.Investors should consult with their broker concerning their brokerage firm’s exercise policy i.e. what is the firm’s automatic exercise policy and the firms deadline to submit exercise instructions?

 

Discussion

Exercise of our options is a procedure we can control almost 100% of the time. If we bought an option, we can instruct our broker not to exercise at the threshold amount. If we sold an option, we can buy it back prior to expiration. I have also written extensively as how to avoid early exercise.

 

Upcoming live events

October 17th, 2016

Austin, Texas

Registration link and information

November 5, 2016

Plainview, New York

Saturday morning 3-hour workshop at the Plainview Holiday Inn. I am the only speaker and plan an information-packed presentation covering 5 actionable ways to make money or buy a stock at a discount using both call and put options. We will also evaluate the stocks you currently own for option-selling.

December 6, 2016

Options Industry Council Webinar Summit

Tuesday afternoon…information to follow:

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Market tone  

Global stocks were little changed this week along with a small rise in bond yields and sturdier oil prices. Markets seem to be factoring in a December rate hike from the Fed. The Volatility Index (VIX), was nearly unchanged this week at 13.48. Oil prices continued to firm in the wake of an OPEC production cap agreement last week. This week’s reports and international news of importance: 

  • The US employment report for September was weaker than expected, but not weak enough to impact anticipation of a 25 basis point raise in the federal funds target by the US Federal Reserve before the end of the year
  • On the bright side, average hourly earnings rose 2.6% on an annual basis
  • The British pound has had a bad week, dropping to its lowest level since 1985
  • Despite the unprecedented monetary stimulus being deployed by the world’s central banks, global inflation has fallen to its lowest level since the aftermath of the financial crisis. The Organization for Economic Cooperation and Development reported that inflation for the Group of 20 nations fell to 2.1% in August. That’s the lowest level since October 2009
  • The biggest drops came in China and India, who are among the fastest-growing global economies
  • While the eurozone manufacturing sector has shown a recent uptick, the services sector is dragging down the eurozone composite purchasing managers’ index. The composite index fell to 52.6 in September, the lowest level since January 2015. The index peaked at 54.3 last December
  • The UK this week issued its first permit allowing hydraulic fracturing to be used to extract natural gas from shale rock. The permit applies to operations in Northern England. US oil and gas production has surged in recent years with the introduction of the technology

THE WEEK AHEAD

  • The fall meeting of the IMF in Washington, D.C., concludes on Sunday, October 9th
  • The minutes of the September meeting of the Federal Open Market Committee are released on Wednesday, October 12th
  • China releases trade data on Thursday, October 13th
  • US retail sales numbers are released on Friday, October 14th
  • Fed chair Janet Yellen speaks in Boston on Friday, October 14th

For the week, the S&P 500 declined by 0.67% for a year-to-date return of +5.37%.

 

Summary 

IBD: Market in a confirmed uptrend

GMI:4/6- Buy signal since market close of September 22, 2016

BCI: My positions for the October contracts favor in-the-money strikes 2-to-1. I’m leaning slightly defensive because of the upcoming election and Fed watch.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The charts point to a neutral to slightly bullish outlook. In the past six months the S&P 500 rose by 5% while the VIX declined by 17%.

_____________________________________________________

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

17 Responses to “Will My Broker Automatically Exercise Options That Expire In-The-Money?”

  1. Mark October 8, 2016 7:49 am #

    Alan,

    Last week you wrote about poor mans covered call a strategy I am interested in with my limited resources. My question is how it works if the short call is exercised. What happens to the LEAP?

    Thanks,
    Mark

    • Alan Ellman October 9, 2016 11:55 am #

      Mark,

      Generally, once the short call is exercised your broker will automatically exercise the long call to provide the shares for the short call obligation. I would double check with your broker regarding the actual specifics.

      Alan

    • Geoff October 9, 2016 12:14 pm #

      As a side note, if you keep some cash on the sideline, you may be able to just buy back the option and then decide what you do from there.

  2. John October 8, 2016 10:47 pm #

    Alan, I had a question unanswered from last week which was,-
    If a stock is declining in the last contract week from market sentiment, then is it still a good idea to do a rolldown if the commission costs (of the BTC & STO trades) are larger than the trade credits received?
    – Also do the option values always move up/down every minute in conjunction with the stock prices?

    Thanks,
    John

    • Alan Ellman October 9, 2016 12:06 pm #

      John,

      1- I would roll down only to create a net credit. In the final week of the contract there is little opportunity to take advantage of time value to mitigate positions. Closing both legs of the trade is also available to us if the stock is under-performing the overall market.

      2- Yes, option premiums move in conjunction with stock price (Delta). Also, volatility (Vega) and time value erosion (Theta) play roles. Option values change frequently during the course of a trading day.

      Alan

  3. Barry B October 8, 2016 11:04 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 10/07/16.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The Blue Collar Investor Team

  4. Alan Ellman October 9, 2016 7:51 am #

    FREE Blue Hour Webinar now available to all active premium members:

    Our most recent webinar “Using Put Options to Buy and Sell Stock” is now available on the premium site. To access this recording login to the member site and scroll down below the 10% discount link on the left side as shown below.

    CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG

    Alan

  5. Jay October 9, 2016 6:27 pm #

    As a follow up, the way I read Alan’s post about the elections and politics last blog he was reminding us it is more constructive to discuss money than politics.

    I agree. So the nuttier and more embarrassing to explain to our children this cycle gets, and it got more so since Alan posted, the more refuge I take in being a Capitalist first!

    F. Scott Fitzgerald wrote the test of a first rate intelligence is the ability to hold two opposed ideas in the mind and still function.

    I believe the market will react more to this election than any in memory. As a short term option trader I am working on my tactics for either outcome. I want Capitalist me to profit regardless if Partisan me celebrates or pouts :). – Jay

    • Roni October 10, 2016 5:43 pm #

      Hi Jay,
      as Alan says, let’s talk money.
      After yesterday’s political debacle, it seems to me the election will be a non event for the stock market this time.

      Therefore I am planning to stay fully invested, and follow Alan´s prudent 2-to-1 in the money approach for the October contracts.

      Unless something spectacular happens, the FED’s rate policy will probably dominate the market news, and earnings will eventually dictate the mood for November and December.

      :o) Roni

      • Jay October 10, 2016 7:26 pm #

        Hey Roni,

        The market is a better prognosticator than me. Going back to the beginning of records if the market is up in the months going into a Presidential election the incumbent party wins 85% of the time.

        It’s a coin toss now. – Jay

        • Roni October 11, 2016 11:58 am #

          Sorry Jay,
          I do not understand your explanation.

          Roni

          • Jay October 11, 2016 1:17 pm
            #

            Hi Roni,

            Apologies for my lack of specificity!

            In my hobby reading about the market and elections I have seen several studies that suggest if the S&P is up in the 3 months leading up to a US Presidential election the incumbent party wins about 85% of the time. Interestingly I saw no statistics about if it is down. One would assume the incumbent party lost most of those.

            Let’s talk 2016: If you back up 3 months from the Nov 8th election the S&P closed at 2182.87 on Aug 8th. We are trading at 2141 as I write this. A less than 2% difference. Certainly no up trend but hardly a collapse. We have gone side ways.

            Thus my comment that from a market as predictor point of view this race is at best a coin toss with some suggestion the incumbent party better hope for a good October :)! – Jay

        • Roni October 12, 2016 11:52 am #

          Thanks for the explanation Jay, now I understand it.

          My difficulty is because I am a Brazilian, and my English is sometimes faulty, Especially when expressions like “incumbent” for example, which are quite ordinary to you, are unknown to me.

          So I look it up in “Google translator”, and “synonims”, and finally I end up deducting that incumbent means the party in power.

          Please never give up on me.

          Roni

  6. Andy October 10, 2016 12:42 pm #

    I was wondering how Allan allocates his portfolio. Does he have a core portfolio of blue chips and write monthly covered calls based on the weekly results on a portion of his overall portfolio, or have most of his portfolio based on the weekly charts?

    Thanks,
    Andy

    • Alan Ellman October 10, 2016 3:52 pm #

      Andy,

      I use our Premium Stock Reports exclusively for my covered call writing portfolios. I use the ETF reports for my mother’s portfolio. I use the same watch lists available to our premium members, nothing more.

      Alan

  7. John October 11, 2016 4:10 am #

    Alan, I’m needing to know of 2 questions about the returns, but for the moment it’s the report I have thoroughly divulged through that has me a bit baffled whether to use it, for coping through these various exit strategies:-

    1. So what I mean is for the stocks that I am trading off the premium report then do I need to constantly check them for if I need to readjust my view on them if wanting to do an exit strategy?
    Like keep checking the Industry rank, R/R & beta values,- and if Industry rank & R/R drops(or beta increases when in a volatile market), then shouldn’t I maybe be more cautious on my exit strategies?(for instance:- roll-down ITM, instead of ATM, etc…)?

    2. Would you be able to predict if my months return would more likely be positive or negative, if not only was I to play the bid-ask spread on every option trade in the month but also if the commissions were also included for the return?(so it’s a positive versus a negative?)

    3. And also when you try to outperform the S&P500 then are you hoping your monthly return each month is greater than the markets return, or that your overall yearly return is greater,- as there is a difference?

    I will try also to remember from your previous answers to not bother so much for roll-downs in last contract week. That would leave me to either take no-action and hope for no further loss, or to close-out any showing some underperformance.
    Thanks for the great answers you always give out.
    John

  8. Alan Ellman October 11, 2016 2:28 pm #

    John,

    1- Great question frequently asked by new members. Once a position is entered, it is managed as per our exit strategy arsenal detailed in my books and DVDs. We recently added a note in the key on page 2 of the stock reports to this effect as shown below. If a position is closed, we use the most recent report for replacement stocks.

    2- Positive!!!

    3- There may be a few aberrations but assuming we have mastered the 3 required skills (stock selection, option selection and position management), we should routinely out-perform the S&P 500.

    CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG

    Alan

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