Hey everyone.
This is Kirk here again at OptionAlpha.com.
In this video, we're going to go through the entire options expiration and assignment process,
and basically give you a rundown on everything that you need to know.
Now for new traders, expiration and assignment can be a little scary and confusing, and I
get that.
But in today's video, we're going to break it down in simple bite-sized chunks that give
you a clear understanding of how it all works.
And again, clear understanding equals confidence in what you're going to be doing as you start
getting deeper and deeper into options training.
First, it's important that we remember that options contracts have a finite expiration
date and that they are derivatives of any underlying stocks or ETFs or indexes.
Therefore, they are regulated different than an actual stock.
So, I first want to introduce options expiration and assignment by talking about the Options
Clearing Corp., or OCC.
Now this is the company, regulatory body, whatever you want to call it.
And that's jointly owned by all the exchanges that trade options, and they issue all the
options and control all the controls and effects all exercises and assignments.
And what's really important to understand about the OCC is that they basically guarantee
all trades by acting as a counter party to any purchase or sale of options, thereby providing
a liquid market to trade.
Now, I'll get to a little graph here in a second that kind of describes what OCC is.
But again, it's their acting as a counter party to guarantee all trades.
They're not acting as the other person that you're trading with.
So, for example, if you're an option buyer, you're not buying options directly from the
OCC.
They're not going to be the other party involved.
You're still going to be buying options from an option seller, but the OCC is going to
kind of be the person in between there that guarantees that if one party doesn't pay or
can't provide payment that the other party has made whole.
So that you know that if you buy an option or sell an option, and make money on that
trade, that someone is going to be there to pay those profits to you.
So the OCC, like other clearing companies, is the direct participant in every purchase
and sale of an option contract.
They act as kind of the "go between", they kind of "barrier" between an option buyer
and option seller.
But again, they guarantee everything, that's what's really important here.
So, here's a quick little graphic we've gone over before, but it's worth going over again.
Again, if you are an option buyer, in this case, then what you want to do is you would
want to submit payment to the OCC.
Okay, again, they are acting as not the middle man but as the clearing part of it to guarantee
the trade.
They give that payment to the option writer, or the option seller.
The option writer then gives the OCC their option contract, which then delivers the option
contract to you.
Now this all happens in a split second, right?
And everything that we do in options trading happens in a split second.
But in the case of this video, what's important to know is that there is an intermediary here
that guarantees payment and liquidity.
So there's an option writer and an option buyer, or an option seller and an option buyer,
doesn't matter, someone is going to be there to guarantee that if this person decides if
they can't pay ... Don't have enough money in their account, whatever the case is, for
some weird reason that they can't do it, OCC will make you whole.
And that's really the key part here.
Now remember, options are expiration dates.
We usually show these here at Option Alpha with vertical lines on our chart.
There's ways you can do that on a lot of different broker platforms, I like to visually see it
by showing these vertical green or vertical red lines on my chart.
But you can consider these kind of like the make or break points.
For right now, the time that we did this video, we took this screenshot here of a stock and
you can see this is where it's trading.
And basically these are the different options' expiration dates.
So we could have the monthly dates, you could have weekly dates.
But basically this is the time frame you need the stock to move before you could either
make money or not.
That's what's really important about option expiration dates.
Again, we've got a great little calendar and resource guide here on Option Alpha that you
can download.
We usually have this current year plus a couple current years out into the future if you've
ever wanted to check that out.
Again, it's completely free.
The one that we use gives you all of the market holidays as well so its very easy so for example
January 1, that's New Year's, that's going to be a market holiday, and then we've got
March, if there's a market holiday there, whatever the case is.
And it also gives you the expiration dates for the monthly contracts and the quarterly
contracts.
So in this case this is going to be the actual expiration date for monthly contracts in January,
again it's all the third Friday in the month for the monthly contracts, that's the expiration
date.
The expiration date, or the day they actually expire, and everything transfers over is actually
that following Saturday, so that always happens on the following Saturday.
So again, really cool resource again 100% free here at Option Alpha.
So, a couple little quick tips before we get into the exercise and assignment process for
options.
Again, expiration day for equity and index options is the Saturday immediately following
the third Friday of the expiration month (except obviously when Friday's a holiday, in which
case it was brought forward by one day to Thursday).
Okay, so again you can check our calendar that we have, it's always there.
But actual options expire on Saturday, the last day they can trade is Friday.
Most people consider Friday really the last expiration day.
So again, for American-style index option contracts the last trading day is generally
the third Friday, again unless it's a holiday in which case it brings forward to Thursday.
For European-style index option contracts, and again we'll get into all this here later
on in the video, but it's important to not right off the bat, the last trading day will
the business day, generally Thursday, preceding the day in which exercise settlement value
is calculated.
An American-style options may be exercised at any time prior to its expiration, and at
anytime up to an including the third Friday of expiration month.
That's why third Friday is always considered to be the last trading day.
So you can see here, back on our calendar, basically American-style options can be exercised,
assigned anytime including that last Friday.
So, last Friday of the expiration cycle is usually the time where you want to get something
done or make a change.
A European-style index option may only be exercised during a specific period of time,
just prior to its expiration.
Now this is generally the last Friday.
Now we'll get into the differences between European and American style options, but I
wanted to introduce this real quick because I think most people gloss over it, and I want
to make sure we have clear understanding that there are differences in American-style versus
European-style.
And it's not necessarily that those are American options on the American market versus European
options on the European market, it's a style of contract, okay?
So first, before we get into that, let's talk through the actual options exercise process.
Now this is really important because you have to clearly, clearly understand what happens
if you decide to exercise your option.
Now there's tow different things we have to talk about right?
There's the options exercise, and then options assignment.
Exercising an option is when you are an option buyer and you decide to exchange your option
contract for the actual shares of underlying stock.
In this case, we'll use a call option in both examples.
Now option assignment, which we'll talk about here next, that's when you are the option
seller and the option buyer has decided to exercise their contract and now you have to
give up your shares of the actual underlying option, okay?
So that's what's really important here as we go through.
Now options exercise obviously starts with a call option holder or call option buyer,
or put option holder or put option buyer, deciding to exercise their contract.
So, whatever that happens, with American-style options, which is 90% of the market, 95% of
the market, that's going to happen at anytime until expiration.
So whenever that person decides "I want to go ahead and exercise my option, they basically
submit that request to their broker", okay?
Now that can in the form a phone call, it can come usually in the form of going into
your online account, and choosing the option to exercise the option versus to sell it back
to the market, or whatever the case is.
But, whatever they do, they submit that request to their broker, so whoever your broker is,
then receives that request.
Immediately the broker sends a notice of exercise to the OCC.
So again, this is why I want to talk about the OCC first in this video because now you
can see where the OCC kind of comes into play here a little bit more.
Now the OCC receives that request immediately, and they randomly select a member firm who
is short an exercise call and assign them the exercise.
Now this is the key point, most people assume, sometimes when they get into trading, that
when you have a contract with somebody else for the entry, meaning if I buy an option
from you and you're the option seller, that immediately we're tied together, and if you
decide to do something that reflects upon me and visa versa, that's not the case, we're
jus parties involved for that initial contract.
But what happens in the exercise an assignment process is that it is randomly generated,
meaning it's randomly assigned between brokers and the actual call writer.
So you don't know if you're going to get assigned somebody's contract or not, it's all randomly
done.
So the first thing that happens again is that that OCC randomly selects a member firm, so
they can select your firm, or randomly select a different firm.
From there, the firm will select on a random basis some of their clients that have those
short options.
So again, random firm, check, random assignment of the call seller, okay?
And at that point then the call seller will then deliver the shares back through the process,
okay?
This is again the options exercise process, this is if you're an option holder, an option
buyer, and you decide to convert that option contract into underlying shares whether long
or short, all right?
Now, let's go on the other side and talk about the option assignment process.
It's all the same stuff, but I just want to talk about it a little bit different.
Again, what happens now is that if you are an option writer or an option seller, you
will get assigned a contract.
Now you don't know when this is going to happen, because it's all random.
If you do get assigned a contract, you'll get notice from your broker that you've assigned.
Once that happens, then you'll have to deliver the contract to your broker, right?
And that contract will then be converted into the shares, and the shares will then be delivered
to the OCC.
So again, we kind of come full circle here, and now the OCC receives the shares that came
out of your account.
Remember you got randomly assigned through this process that we just talked about in
exercise, and so now that you've been assigned, you deliver the shares to your broker, the
broker delivers them to the OCC.
Immediately the OCC then delivers the shares back to your broker, or the option buyer's
broker, who then delivers the shares to the option buyer, okay?
So this entire process happens very quickly and again the parties involved here include
the OCC, which happens to be the intermediary, they guarantee everything, they double check
everything, and then your brokers act as that direct links to the OCC and between you and
the option buyer and option seller, okay?
So again, hopefully that clears up the entire process of exercise an assignment, and again
we'll get through some more stuff here as we get further into this training, all right?
Now though options can be exercised or assigned at any point, and we've talked about his before,
it's important to remember that the vast, vast majority of options are assigned the
week of expiration- and really the last few days.
Now this is really a big one because even though you can technically be assigned at
any point.
So, I can choose as an option buyer to assign my contract to you as the option seller at
any point, you have to really understand that as an option buyer, if I sign early, I lose
any time value or extrinsic value that that contract has.
And so, that means that generally most contracts are assigned, or exercised, however you want
to look at it.
They are assigned or exercised the week of expiration, because they are nearing their
intrinsic value, they don't have this extra component of volatility and time decay.
Again, if I exercise early, I lose that as an option buyer, and so that's why most option
contracts are not exercised incredibly, incredibly early.
They're actually exercised later on in the cycle, the vast majority of that coming the
week of expiration and really, the last few days, so Wednesday, Thursday, Friday.
So what this means is that you shouldn't really worry about expiration of an assignment as
you're trading.
I think when we went back recently and tracked all of our trades for the last five years,
and we've done thousands of trades over the last five years, we were assigned on contracts,
I think just over 1%, like 1.2% of the time, we were assigned contracts.
So, it is very rare to happen.
And again, you got to deal with stuff the week of expiration, you can't run yourself
all the way to the end until the limit, and hold a contract that's in the money the few
days of expiration.
You do have to manage that risk obviously, and we teach you how to do that here at Option
Alpha.
But, as far as numbers go, we've only been assigned about 1.2% of the time over the last
five years.
So that gives you a little bit of confidence to know that most of this assignment exercise
process doesn't happen all too often.
It can definitely happen, and if you trade long enough it will.
But it's not something that you need to freak out about and hyperventilate about.
All right, so let's continue to go through here, we've got a couple more things that
we need to cover.
First, we need to cover the difference between physical and cash settlement.
Now physical settlement are option contracts whereby settlement requires the actual physical
delivery of the underlying security.
Most of the options you will find in the marketplace are physically settled options, like stock
options, since the underlying stock is transferred and delivered.
Now this is what we've generally talked about all through Track 1, most of the trading that
we do at Option Alpha is in regard to physical settlement, where if you are assigned or if
you exercise, you want to get or receive the underlying shares of whatever you're trading.
So for example here, we have Google stock.
If you're trading Google options, you'd want to get or receive Google shares, okay?
Now there is a difference because there are also cash settled options.
And these are options/contracts whereby settlement is done via the payment of cash at exercise
at expiration.
This is typically the settlement that is preferred when delivering an underlying security that
is inconvenient, costly, or simply impossible to give.
And you want to think here of the SPX and VIX options.
Most index options are cash settled, and the reason that they're cash settled is that you
can't go out and buy an index, you can't go out and buy SPX, it's just a benchmark index.
So, although there is options on SPX, when actual assignment or expiration comes, you
actually get just the cash value of your options of your contracts at expiration.
So, you either make money or you didn't, there's no actually delivery of the SPX index, because
it's nonexistent, it's impossible to deliver the index, okay?
Now most of the stuff that we do here at Option Alpha, like I said, is physical settlement,
this does include ETFs, because you can buy ETFs, those are physical securities.
But, a lot of things out there are cash settled as well, and it's mostly some of the index:
SPX, RUT, VIX, NDX, etc.
Now again, we talked about this before, but it's worth mentioning here again towards the
end again, is that there are two different types of options, and it's really important
that we distinguish between these.
The first is American options.
You can American-style options any time before expiration.
So for example if you own a call option and there are fifteen days before expiration,
you can choose to exercise that option and buy stock at the strike price.
Now this is different than European options.
European options are only exercised at expiration.
And so most of the index and forex options (again like RUT, SPX, NDX, etc. that we talked
about) are typically European-style, and the reason they are is because those are usually
cash settled indexes as well because you're not going to do an early exercise of SPX and
buy SPX, it's impossible to get delivery of an index.
So that's why most of those are European-style.
Again, they're less common, just like cash settlement is less common.
Most of the options that are out there are American-style, which means they can be exercised
anytime before expiration.
What's really, really important to remember here about American-style options, since this
is most of what we do here, is that this is only dealing exercise and assignment.
It has nothing to do either European or American-style with the ability to buy or sell contracts.
So, if you have an American-style option or European-style option, you can still buy and
sell those contracts all the time, back and forth, as many times as you want, up until
expiration.
You can buy a call, sell it back, buy a call, sell it back, buy a put, sell it back, buy
a put, sell it back, you can do this all the time.
It's only when it comes to the actual exercise of that option where you want to convert a
contract into underlying shares, that's where the difference comes in here between American
and European styles.
So, hopefully that makes sense.
Again, most of what we do here at Option Alpha is physical settlement and American-style
options, and again, that's the most widely used type of contracts out there.
So, hopefully this has been a really good video tutorial on the entire options expiration,
assignment exercise process.
Again, I appreciate you taking the time to watch it.
If you have any comments or feedback, please leave them in the comment section below.
If you love this video, please help us out by sharing it online, it's one of the ways
we spread the word here at Option Alpha.
And until next time, happy trading.