Investor's wiki

Automatic Exercise

Automatic Exercise

What Is Automatic Exercise?

Automatic exercise is a system executed to safeguard an option holder where the Option Clearing Corporation (OCC) will automatically exercise an "in the money" option for the holder, typically at an option's expiration date and time. For ordinary listed equity options in the United States, expiration typically falls toward the finish of trading on the third Friday of each and every month.

With automatic exercise, a trader or investor who overlooks the date, or who is generally unfit to physically train their broker or clearing firm to exercise their in the money options, will have the benefit of having their profitable contracts dealt with for their sake.

How an Automatic Exercise Works

Options contracts give their holders the right, yet not the obligation, to buy (for a call option) or sell (for a put option) a set amount of the underlying security at a pre-decided strike price, prior to the agreement's expiration date (for a American style option. European options must be exercised upon expiration).

Illustration of Automatic Exercise

Say a trader purchases the $50 strike call on XYZ shares when the stock is trading at $40. This gives the trader the right to purchase XYZ stock for $50 later on. At expiration, assuming XYZ shares have ascended to $42, the trader will let the calls lapse worthless on the grounds that there is no benefit to buying the stock for $8 higher than the current market price. Nonetheless, if the price of the stock ascents to $60, the trader will need to exercise his right to purchase shares at $50 to make an immediate $10 profit for every share (minus the premium paid).

Yet, assume the trader fails to remember that it is the third Friday of the expiration month — or doesn't approach their broker since they are on vacation, or generally incapacitated. Assuming that they fail to exercise their in the money options, they will lose the profit opportunity. Luckily, the Options Clearing Corporation (OCC) — which is the central clearing house for all listed options traded and exchanges in the U.S. — will automatically exercise these options for his sake.

The OCC has provisions for the automatic exercise of certain in-the-money options at expiration, a strategy likewise alluded to as "exercise by exception." Generally, the OCC will automatically exercise any terminating equity or index call or put in a customer account that is $0.01 or more in-the-money at expiration. Be that as it may, a specific brokerage firm's threshold for such automatic exercise might be equivalent to OCC's (albeit most are). For instance, in the event that you own a call option with a strike price of $50, and the stock closes at $50.01 on the day your call terminates, your broker will doubtlessly exercise your option.