Covered call writing and selling cash-secured puts obligates us to buy or sell shares at the strike price by the expiration date. Exercise will generally occur if the strike is in-the-money by 4 PM ET on expiration Friday (usually the 3rd Friday of the month). Frequently we do not want to sell our shares or purchase the option holder’s shares so we buy back the option to avoid assignment. There are times when it is difficult to assess the likelihood of exercise so understanding how the process works is important to retail investors and the focus of this article.
How will broker manage my expired in-the-money strike?
This can vary from broker-to-broker. Our account agreement forms detail the specific procedure for our brokerage. The Options Clearing Corporation (OCC) uses a $0.01 threshold (strike in-the-money by $0.01 or more) but our broker may use a different threshold amount. Option buyers (holders) can submit instructions to the broker not to exercise even if the strike is in-the-money.
Exercise by exception versus automatic exercise
Exercise by exception is the administrative procedure whereby the OCC exercises all in-the-money strikes by the threshold amount unless the member submitted instructions not to exercise. This process is frequently incorrectly referred to as automatic exercise ignoring the fact that the clearing member always has the right not to exercise.
Control from the perspective of option buyers and sellers
Option buyers can choose to exercise in-the-money strikes by taking no action and letting the exercise by exception process move forward. They can choose not to exercise these in-the-money strikes by submitting notice to the broker to that effect.
Option sellers can avoid exercise by buying back the option prior to 4 PM ET on expiration Friday. We can remain subject to exercise by taking no action and letting exercise by exception move forward.
After-hours activity- how trading after 4 PM impacts exercise
After-hours trading can make option strikes move in and out-of-the-money. Some stock index options like SPY (NYSE:SPY) and QQQ (NASDAQ:QQQ) trade through 4:15 ET but are settled based on the 4 PM close. This may result in unexpected exercise. Furthermore, professionals have an hour and a half after the 4 PM close to make a decision as whether to exercise. In addition, unexpected after-hour news like an FDA drug approval can dictate whether our options are assigned. All this behind the scenes after hour “monkey business” tells us that if we want to be sure of not getting assigned for strikes near-the-money as 4 PM approaches, we must buy back the options.
Discussion
Generally, strikes that are in-the-money by $0.01 or more will be exercised. Option holders reserve the right not to exercise and option sellers can always buy back the option to avoid exercise. After-hours trading may also determine exercise for near-the-money strikes.
Market tone
Global stocks rose this week as markets anticipated fiscal stimulus in the wake of Donald Trump’s election. Infrastructure, financial and pharmaceutical stocks were among the best performers. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), fell to 14.17 after the election outcome became clear from 21.5 a week ago. Oil prices stabilized at lower levels amid continued concerns over a potential oversupply. West Texas Intermediate crude fell to $43.90 from $44.00 a week ago while global Brent crude dipped to $45.10 from $45.50. This week’s reports and international news of importance:
- After the surprise victory for Republican presidential candidate Donald Trump, the market initially dropped the 5% limit in after-hours trading. Then the S&P 500 futures reversed course and closed solidly higher on Wednesday. An expected policy mix of tax cuts and increased defense and infrastructure spending, along with reductions in government red tape sent the Dow Jones Industrial Average to a record high close on Thursday
- Growth and inflation expectations have risen since the election which keeps the central bank on course for a rate hike at its December meeting
- Justin Trudeau, Canada’s prime minister, said that he is open to renegotiating North American Free Trade Agreement with the United States once President-elect Trump takes office in January. Canada and the US have the largest trading relationship in the world. International trade was a prime focus of the Trump campaign and shifting trade policy is a potential source of market uncertainty in the months ahead
- Chinese trade data remained soft in October, suggesting that global demand remains subdued Exports fell 7.3% last month, while imports fell 1.4
- OPEC’s new World Oil Outlook predicts that crude prices will not top $60 per barrel until the end of the decade, $20 per barrel below its decade-end forecast from a year ago
- Prices for industrial metals rose sharply in anticipation of ramped up infrastructure spending under a Trump administration
THE WEEK AHEAD
- Japan reports Q3 gross domestic product on Monday, November 13th
- China releases retail sales and industrial production data on Monday, November 14th
- The United Kingdom’s consumer price index is released on Tuesday, November 15th
- Q3 eurozone GDP is reported on Tuesday, 15 November
- October US retail sales data are reported on Tuesday, November 15th
- October US industrial production data are reported on Wednesday, November 16th
- The minutes of the October meeting of the European Central Bank’s Governing Council are released on Thursday, November 17th
For the week, the S&P 500 rose by 3.80% for a year-to-date return of +5.90%.
Summary
IBD: Market in confirmed uptrend
GMI: 5/6- Buy signal since market close of November 10, 2016
BCI: The surprise Republican sweep has left half of us elated and half of us frightened. As investors, we should be neither. Non-emotional investing is the key to successful investing. There will be near-term volatility in our markets initially due to the uncertainty of a Washington “outsider” leading our great country. The markets will then settle down to a norm and then we can craft our investment plan. We have so many tools at our disposal to invest defensively or aggressively depending on the statements the markets make post-election.
This challenge pales in comparison to what many of us went through in 2008. We invest in corporations that will continue to make money and that may be difficult to embrace in what many will view through a post-Brexit-like initial market volatility. From there, opportunities will present themselves.
I am currently 100% in cash and looking for the most appropriate re-entry point. Elation or fear will not be part of that decision-making equation.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a slightly bullish outlook. In the past six months the S&P 500 was up 5% while the VIX declined by 4%.