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Option Market Basics - Option Settlement << Back
Rights & Obligations
Remember that an option contract represents a right or an obligation between two parties. The holder or buyer of a call option contract has the right to purchase shares in the underlying security for a specific price (known as the strike price) for a specific period of time. The party that has written or sold the call option contract assumes the responsibility of delivering the security at the strike price.
Conversely the holder or buyer of a put option has the right to sell shares in the underlying security at a specific strike price and for a specific period of time. The party that has written or sold the put option has assumed the responsibility of buying the security at the strike price sold.
The options writer is obligated to deliver or purchase shares in the underlying security as long as they are short the put or call contracts. This transaction will take place if the option contracts have an intrinsic value or in other words are “In-the-Money “ on the expiration date.
These rights and obligations are fulfilled through a process known as exercise and assignment. These terms refer to the purchase or delivery of the underlying shares represented by the option contracts. Options exercise takes place when the owner of a call option uses their right to purchase the underlying shares at the strike price represented by the contract held. In the case of a put option, this refers to the use of the put holder’s right to sell the underlying shares at the strike price of the contract held. Option exercise is considered a right and is not always followed through with. The long option contracts may be sold before expiration.
An obligation is created by selling or shorting an option contract. If an option holder exercises their right, the option writer is said to be assigned to fulfill their obligation. The call writer must deliver the underlying security at the strike price. The put writer must purchase the underlying security at the strike price. As mentioned previously, this process will only take place if the options contract has intrinsic value or in other words is an “In-the-Money “. To avoid assignment on an “In-the-Money “ option, the option writer must buy back the short position. Remember, an “Out-of-the-Money” option, will expire worthless alleviating the writer from their obligation.
There are two styles of options exercise and assignment, American and European. With an American style option, the right to exercise can be initiated from the time of purchase until expiration. Early exercise is a possibility, meaning the option writer may be assigned to fulfill their obligation if there is a distinct financial benefit to the option holder. Most Canadian and U.S. options are American style.
European style options can only be exercised on the last trading day before the expiration date. Remember that options expiration falls on the Saturday following the third Friday of the Expiration month. Therefore, the third Friday of the Expiration month is the last trading day. As with American style options, European style options can only be exercised if they are “In-the-Money “. If an option has no intrinsic value it will expire worthless. It is important to know what category an option contract falls into and how the contract is to be settled on expiration if it is “In-the-Money “.
Cash Settled options
“In-the-Money “ options or options with an intrinsic value may be settled in two different ways on the expiration date. Cash settled options do not require the physical delivery of the underlying security. Instead, the difference between the market value of the underlying security and the strike price of the option contract is calculated and the associated dollar amount is added to the account.
Cash Settled examples
Some examples of cash settled options include Index options, Interest Rates options and some currency options.
Physically Settled options
Physically settled options require the actual delivery of the underlying security in the equivalent number of shares represented by the number of option contracts. Full payment per share in the amount of the strike price will be exchanged between the option holder and the option writer and the equivalent number of shares will be delivered or purchased accordingly.
Physically Settled examples
Some examples of physically settled options are equity options and most EFT options.
In an effort to insure that all rights and obligations are met by the holders and writers, Options Clearing Corporations have adopted an automatic exercise rule. In Canada, if an option contract is 1 cent “In-the-Money “ at the end of the trading day on expiration Friday, the clearinghouse will assume the option holder wishes to exercise their right.
As a call option holder, the underlying will be automatically purchased at the strike price and the shares will be delivered to the holders account. As a put option holder, the underlying security will be automatically sold at the strike price and the equivalent cash will be added to the holders account. It is important to note that if the put holder does not already own shares of the underlying security, a short position is created. To avoid automatic exercise, the option buyer or holder can offset the position by simply selling the contracts prior to expiration. The option holder can also advise their broker not to auto exercise. As an option writer or seller, there is no override. If the option contract is “In-the-Money “, assignment is inevitable. The short position must be off set or bought back prior to the end of the trading day on expiration Friday.
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