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:
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.
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?
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
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:
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%.
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,