shares of the underlying stock. This is called
physical delivery or physical settlement.
On the other hand, most index options, such as SPX (S&P 500), are
cash
settlement
rather than physical delivery. In other words, if the long position
exercises an index option, he receives the cash value of the option rather than
taking actual delivery of all the stocks in that index. Just realize that not all options
settle in physical delivery. As you continue to learn more about options you will
hear the terms “physical settlement” and “cash settlement,” and it’s important you
understand what these terms mean.
Exercise Versus Assign
We said earlier that it is the long positions who get to exercise their options.
What do short positions get to do? Nothing. Remember, short positions have no
rights. The short position may get a phone call from his broker stating that he has
just purchased or sold shares of stock due to a call option he sold. If you are required
to buy or sell shares of stock due to a short option, it is called an
assignment.
If you get assigned on an option, your broker will notify you the next business
day to inform you of the assignment. He may say something like, “I’m calling to
inform you that you’ve been assigned on your short call options and have sold 100
shares for the strike price of $50.”
The words exercise and assign should only be associated with long and short
positions respectively. However, in the real world, if you are assigned on a short
option, brokers may say things like “you got exercised” on an option even though
it is technically incorrect. Long positions exercise. Short positions get assigned. In
truth, it doesn’t really matter in practice if an incorrect phrase is used such as “you
got exercised” rather than “you got assigned” as long as you understand the message.
However, if these terms are used, you do need to understand the difference. Most
books and literature on options carefully choose between the words “exercise” and
“assign” and you need to understand the actions they are referring to.
Let’s work through some examples to be sure you understand. If you are long a
call option, you have the right to exercise it and buy shares of stock. If you are short
the call, you might get assigned and be required to sell shares. If you are long a put
option, you have the right to exercise it and sell shares. If you are short the put
option, you could get assigned and be required to buy shares. To continue further,
if a long call holder uses his call to buy shares of stock he would say, “I exercised my
call.” The short call holder would say, “I got assigned on my call.”
It is important to understand that once you submit exercise instructions to your
broker and the shares and cash have exchanged hands it is an
irrevocable transaction.
Make sure you want to exercise before submitting instructions. Also, many firms
have cutoff times after which exercise instructions cannot be changed (even though
the shares or cash may not have yet been exchanged). Check with your broker as to
what these cutoff times are before you submit exercise instructions.
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