Bill Johnson, Director of Education at Options University Ask Bill Your Question August 09, 2007 Q: When an option expires in the money what is the result? Would the broker automatically buy the stock, or would one receive the intrinsic value as a credit? What would happen if you had insufficient funds in your account to buy the stock at expiration? A: Hi Roger, If you are holding an in-the-money option near expiration, the result is that you have some value (not necessarily a profit) that needs to be acquired. There are basically two ways you can capture this value and each has a very different set of risks. Your first choice is to just close (sell) the option in the open market, which is what about 60% of the traders do every month. How much is the option worth? We know that all options, regardless of the time remaining, must be worth at least their intrinsic value otherwise arbitrage is possible. When we're at expiration, the time value is zero so all in-the-money options must be worth exactly their intrinsic value. So if you are holding a $50 call with the stock at $56 it must be worth exactly $6. In the real world though, you will find it will be worth slightly less due to the bid-ask spread but you should collect roughly $6 by selling it in the open market. It's important to understand that you must initiate the trade and that your broker will not do it for you. Your second choice is to exercise the call. When you exercise the call, you will receive 100 shares of the underlying stock (assuming it is not an adjusted option that controls a different number of shares) and you will pay the strike price per share. Using the above example, you would receive 100 shares of stock for every call you exercised and would pay the $50 strike per share, or $5,000 per 100 shares of stock. Notice that either choice nets you the same amount of money (has the same reward) but comes with a different set of risks. If you close out the $50 call in the open market, you'd receive $6 per share, or $600 per contract in cash. That cash value is locked in and will not change regardless of where the stock trades in the future. However, if you exercise the call, you will pay $50 and receive stock worth $56, which also represents a gain of $600 per contract. Unlike closing the call though, this $600 gain is an unrealized gain (not locked in) since you now own the shares. Because you own the shares, you will participate in future gains - and losses - of the stock. But at the very moment you close the call or exercise it both choices are worth the same ($600 in this example). It's just a question of whether you wish to continue to hold the shares or the cash. There is a special case of an in-the-money option that you should be aware of too. If your equity option is more than five cents in-the-money and you do not close it in the open market or you do not exercise it then the OCC (Options Clearing Corporation) will exercise it for you. The OCC currently exercises all options that are at least five cents in-the-money at expiration unless you notify your broker to not exercise. (They will also exercise all index options that are at least one cent in-the-money.) This is the only time your broker will take action without instructions. If your options is automatically exercised and you do not have the money in your account the exercise will still go through thus leaving you with a debit balance on the account. This balance must be paid within three business days unless you sell the shares that same day (usually Monday). This is the only time that you do not need to meet the 50% Regulation T (Reg T) requirement. Still, you are at risk if the share price should fall on the open. This automatic exercise feature was designed to keep investors from inadvertently losing this nominal intrinsic value. However, in many cases it causes unwanted surprises. Because of this automatic exercise feature, the best way to handle options at expiration is to either 1) close them in the open market or 2) instruct your broker to exercise the option or 3) instruct your broker to not exercise the option. In either of these cases, there are no surprises on Monday morning. If the option is at least five cents in-the-money and you wish to exercise the call you could, theoretically, do nothing and take the automatic exercise. But even in this case it's best to contact your broker to let him know of your intentions so that there are no miscommunications. In fact, some brokerage firms may sell your shares on Monday morning if they are acquired by automatic exercise and they do not hear from you. So always contact your broker when exercising an option. Options University | 866-561-8227 | 925 South Federal Highway | Boca Raton, FL 33432