Option Basics

[Mofra]

hey guys
in regards to the asx, whats happens when an option expires ITM? does it expire worthless if u dont close it out, or is the intrinsic value of the option settled automatically?

Heya potato,

Most options service providers in Australia offer automatic exercise for long all in the money options, for those on the short side you will be obviously forced to meet any normal obligations as a seller.

Might have to re-visit the fine print in the terms & conditions for your Options account as it is broker specific.

Hope this helps

 

[sails]

Potato, I agree with Mofra that brokers in Aus have different policies on automatic exercise, so it would be a good idea to check this with your broker.

However, I was told by someone at the ASX recently that there is no automatic exercise on index options (eg XJO) in Aus. So if you have an ITM long index option on expiry day, it would appear that the broker needs to be advised that you wish to exercise to get the cash back into your account! Seems strange when it's cash settled, but I guess they have their reasons.

Spitrader1 - if you are reading this - do you know the reason?

 

[potato]

thanks for the reply guys.

 

[radarz]

I'm not sure what happens on the ASX, but in the US, if the option is in the money by a certain amount (i.e. 25c) the option is automatically exercised, unless you specify for it not to be. If no exercise, you will lose the intrinsic value of the option. So be sure to know the mechanics of this.

As a rule, I almost always close out long options before expiry, unless I particularly want the shares (almost never). This is the most efficient way to capture intrinsic value, as once the option is exercised, you are exposed to unlimited risk via the share.

Only cash settled options (such as index options) will be settled in cash on expiry.

I purchase a put option. I choose to close out rather than trade this option back into the market. Is it required that I have the shares ready to sell?

 

[wayneL]

I purchase a put option. I choose to close out rather than trade this option back into the market. Is it required that I have the shares ready to sell?

Yes... unless you are able and want to be short the shares.

The term you should use is "exercise". "Close out" means to sell the puts to close the trade.

Cheers

 

[sails]

I purchase a put option. I choose to close out rather than trade this option back into the market. Is it required that I have the shares ready to sell?

Hi Radarz,

I'm not sure what you mean by closing out instead of trading back into the market. If this means you are considering exercising your put option without owning the underlying shares, then this is a question for your broker. Some brokers will allow it - usually with strings attached (an example would be a potential requirement to close out the share position by a certain time the following trading day). However, it really depends on individual broker policies, so suggest you get the answer from your broker.

Cheers.

 

[radarz]

Thanks for the quick reply guys!

I know that ultimately I need to seek full clarification from a qualified broker. I'm just seeking initial advice first so that I don't waste both mine and my brokers time, not to mention helping myself understand the whole scene more completely.

The aim was to buy put options to gear myself against a stock fall, as opposed to simply short selling on margin. It's a gamble with a set percentage of my portfolio. For example, I wish to take 10% of my portfolio and buy put options over a set time frame with a calculated gamble that the underlying stock is going to fall in value. I don't wish to touch the other 90% of my portfolio. If I get it right (if I get lucky) it should be like I have geared myself to take advantage of a fall.

Does this strategy make sense taking into account that it *is* a non-quantitative calculated gamble?

 

[Magdoran]

I purchase a put option. I choose to close out rather than trade this option back into the market. Is it required that I have the shares ready to sell?

radarz

Here’s something to consider. If you can’t get a fair price for an option that is about to expire, it is not uncommon for some people to inform their broker (this may be verbal, or can be electronic depending on the broker) that they wish to exercise their option.

In the hypothetical case here, this is a put option. In the electronic case, the pattern I know is that you exercise the option, then you are required to purchase the exact amount of shares to fulfil the number of shares required to complete your side of the option contract. My understanding is that this must be fulfilled by the end of that trading day you exercised the option, or you may be subject to fail fees for breeching the contract.

As Margaret (sails) correctly points out, different brokers may have different procedures, and full service brokers may allow a range of alternatives depending on their operational procedures (it is conceivable that some may lend you the shares on the condition you purchase the requisite number of shares at some point).

In essence it is a kind of shorting the share if you borrow in this case, and the mechanics can vary widely from broker to broker. Many will not allow you to do this, but if you have a big account, anything is possible, but brokers are very good a eliminating risk where they can, so you will have to have deep pockets, and probably have to commit collateral if they accept.

If you have a portfolio, then it’s simply a case of allocating the correct number of shares from your account to fulfil the contract.

Hope that helps, but have a thorough read of the terms and conditions on the ASX website, and perhaps contact your broker/s for more information.


Regards


Magdoran

 

[sails]

...
In the hypothetical case here, this is a put option. In the electronic case, the pattern I know is that you exercise the option, then you are required to purchase the exact amount of shares to fulfil the number of shares required to complete your side of the option contract. My understanding is that this must be fulfilled by the end of that trading day you exercised the option, or you may be subject to fail fees for breeching the contract....

I had not realised this (my highlight above) was another way of handling the exercise of options (eg those that cannot be closed out for at least intrinsic value) until recently when reading about it on one of the ET forums. I didn't think of it with my reply to radarz, so thanks Mag, for pointing that out. It not only removes the risk of fail fees should one be with a broker that charges them, but also removes overnight directional risk.

I have yet to enquire if the brokers I use are OK to do it this way, but I can't see why they wouldn't due to removal of overnight directional risk.

 

[radarz]

I have yet to enquire if the brokers I use are OK to do it this way, but I can't see why they wouldn't due to removal of overnight directional risk.

Overnight directional risk?

 

[sails]

Overnight directional risk?

If you simply owned puts (without the underlying shares available to sell) and decided to exercise them, you will find you are short x number of shares the next day in your account. In essence, a limited risk position (puts) has been changed to an unlimited (upside) risk with the short stock position. May not be a problem, but definately wouldn't want a takover bid or any other really good news the next day! Does that make sense?

 

[radarz]

Makes sense.

Thanks.

 

[money tree]

However, I was told by someone at the ASX recently that there is no automatic exercise on index options (eg XJO) in Aus. So if you have an ITM long index option on expiry day, it would appear that the broker needs to be advised that you wish to exercise to get the cash back into your account! Seems strange when it's cash settled, but I guess they have their reasons.

this is not quite true. it is IMPOSSIBLE to exercise an index option........right? I mean how can you buy shares in XJO?

Cash settled means just that. At expiry, if the option has any intrinsic value, the option writer pays the taker this amount.

Ive been through this process many times. It couldnt be easier or simpler.

 

[money tree]

In the hypothetical case here, this is a put option. In the electronic case, the pattern I know is that you exercise the option, then you are required to purchase the exact amount of shares to fulfil the number of shares required to complete your side of the option contract. My understanding is that this must be fulfilled by the end of that trading day you exercised the option, or you may be subject to fail fees for breeching the contract.

There are other alternatives.

If you own a put option, and want to exercise it rather than lose money on the spread, you DONT need to buy the shares in question. This would take a hell of a lot of capital

You CAN exercise an option (a put in this case) without dealing with the FPO. Simply remove the market risk for your broker, and they will be happy to do the trade on your behalf. How do we remove market risk? In this case, we own a put, so market risk is to the upside. How do we remove upside market risk????

A CALL OPTION !

Which call option? We will be exercising this call option the next day so we dont want to waste money on time premium. Which options have small or no time premium? D.I.T.M ones!

Having said all that, why not sell the option before expiry? Its a hell of a lot cheaper when you consider the buy & sell commissions on two large FPO transactions.

There is a case where its worth exercising, but only my course readers know it.

 

[radarz]

Which call option? We will be exercising this call option the next day so we dont want to waste money on time premium. Which options have small or no time premium? D.I.T.M ones!

There is a case where its worth exercising, but only my course readers know it.

What is D.I.T.M? Something in the money????

What do your readers read? Or, should I say, what do you publish?

 

[Magdoran]

this is not quite true. it is IMPOSSIBLE to exercise an index option........right? I mean how can you buy shares in XJO?

Cash settled means just that. At expiry, if the option has any intrinsic value, the option writer pays the taker this amount.

Ive been through this process many times. It couldnt be easier or simpler.

money tree (Paul),

In defense of Margaret’s comments (sails), my understanding is that XJO index options are European exercise, and are cash settled, but you must exercise these options to get the cash settlement at expiry if you are holding them.

For supporting information, go to:

http://www.asx.com.au/investor/options/index_options_fact_sheet.htm

• Index options are usually cash settled, rather than deliverable. Because it is not practical to physically deliver the shares that make up the index, an investor will receive a cash payment on exercising an in-the-money index option.
• Index options are European in exercise style, meaning they can only be exercised at expiry.
• The exercise price and premium of an index option are expressed in points. A multiplier is then applied to give a dollar amount.

“Even though index options are cash settled, you still need to exercise”

A point though is that you must have a standing instruction for your broker to exercise ITM XJO index options at expiry (if you hold these through to expiry), or actually instruct them to do so if not.


Regards


Magdoran

 

[Magdoran]

There are other alternatives.

If you own a put option, and want to exercise it rather than lose money on the spread, you DONT need to buy the shares in question. This would take a hell of a lot of capital

You CAN exercise an option (a put in this case) without dealing with the FPO. Simply remove the market risk for your broker, and they will be happy to do the trade on your behalf. How do we remove market risk? In this case, we own a put, so market risk is to the upside. How do we remove upside market risk????

A CALL OPTION !

Which call option? We will be exercising this call option the next day so we dont want to waste money on time premium. Which options have small or no time premium? D.I.T.M ones!

Having said all that, why not sell the option before expiry? Its a hell of a lot cheaper when you consider the buy & sell commissions on two large FPO transactions.

There is a case where its worth exercising, but only my course readers know it.

money tree,

Your comment conflicts with my experience and understanding of the process.

The original question was specifically about the mechanics of exercising a put option, and what is required specifically in terms of the supply of the shares to fulfil the contract:

I purchase a put option. I choose to close out rather than trade this option back into the market. Is it required that I have the shares ready to sell?

Mechanics of Exercise:

If you exercise a put option, the contract is to deliver the correct number of shares to the option writer/taker at the strike (exercise) price.

The contract stipulates that you must deliver the shares under the ASX rules. The core question was about the mechanics involved. Either way, the option writer of the put must receive the correct number of shares as stipulated in the contract to fulfil the terms, this is immutable.

You point about exercising the put, and buying the shares taking up considerable capital also conflicts with my experience and understanding. Once you have exercised the put, all my brokers allow me to purchase the requisite number of shares without the need to finance the purchase with any capital because they recognise that the exercise of the option ensures the sale of the underlying is exchange guaranteed. The exercise is considered sufficient.


Alternative: Buying a Call and exercising it to fulfil the contract

If you are suggesting buying an ITM (in the money) call option and exercising it, as an alternative to buying the shares; the case for doing so would be that the time value, spread costs, and the cost of exercising the call (and any other transactional costs) were less than the cost of buying the shares.

The problem with this approach is that usually the case for exercising the put in this case may be that the spread is prohibitive, and if this is the case, the same is likely to be true for the call (but not always – hence the situation should dictate the best alternative, shouldn’t it?).

Also, buying deep in the money calls may actually require significant capital depending on the situation, which might also prove to be prohibitive, especially where buying the shares may not require the capital at all depending on the broker.

Another thing to consider is that you actually receive the shares when you exercise the call in theory (although these immediately fulfil the requirements of the exercised put), hence you usually attract the exercise fee which may be dearer than buying the shares depending on your broker’s fee structure, on top of the transactional costs to buy the call option, hence this may actually be self defeating. In addition this is especially true if the call spread is disadvantageous as well.


While I agree with your comment that it is usually better to sell an option before expiry (especially when there is time value left - Wayne, Margaret and I have covered this topic thoroughly in previous threads), the point raised here was specifically about the mechanics of exercising if you choose to do so. This is also an effective strategy close to expiry if you are trading an illiquid series, and the market maker spread is less advantageous than exercising. Certainly it is not the preferred approach, but I have certainly observed cases where exercise yielded the better financial result, but this is the exception, not the rule.


Regards


Magdoran

 

[sails]

this is not quite true. it is IMPOSSIBLE to exercise an index option........right? I mean how can you buy shares in XJO?

Cash settled means just that. At expiry, if the option has any intrinsic value, the option writer pays the taker this amount.

Ive been through this process many times. It couldnt be easier or simpler.

Hi Paul,

The only mistake I made in my post was I thought this info came in an email from the ASX when it was actually in one of their articles: http://www.asx.com.au/investor/options/how/library/2006/get_on_board_xjo.htm. And here is an excerpt - the highlight is mine:

Cash settled but not automatically

Index options are cash settled on expiry however like all options an instruction to exercise is mandatory. Failure to exercise an ITM option will not result in cash settlement.

An instruction to exercise can be either manual (call broker) or automatic (have your account set to automatically exercise ITM options on expiry). If you’re not sure of the status of your options account contact your broker today.

This may well be broker specific - perhaps you have a broker that automatically exercises all ITM options at expiry including index options.

I also agree with Magdoran's comments regarding the buying DITM calls to cover the exercise DITM puts. IMO, one of the main reasons for exercising is usually because of the difficulty of getting the full intrinsic value (if trying to sell them on the market) due to excessively wide bid/ask spreads. So it makes no sense to me to go through the cost of exercising plus pay slippage and fees on DITM calls as well. Oh well, each to their own, I guess

BTW, Not all brokers charge excessive fees on exercise/assignment - OptionsXpress is one that has a flat rate - currently priced at $30 regardless of the cost of the underlying shares. No fail fees either provided the shares position is closed out the next day.

Cheers

 

[sails]

What is D.I.T.M? Something in the money????...

Yes - deep in-the-money!

 

[money tree]

thanks for clarifying that Margeret.

Ive used 3 different brokers and in each case Ive never had to say squat about exercising, which we can assume means its automatic for them. I know there are some brokers who dont charge $4k in brokerage for buying & selling $300k worth of FPOs but its rare. Its this huge cost that I based my argument on, so it really does depend on which broker you use. This cost can be a huge surprise and is an important point. I also didnt realise it was hypothetical mechanics rather than practical. My bad.

As for ASX articles, they have a funny habit of "inventing" very similar strategies after I publish mine......