Whether you are an options buyer or seller you will want to make sure you understand what expiration, assignment, and exercise mean and how each of these issues will affect your trades. It is also absolutely critical that you have a conversation with your broker about their policies relative to these three issues before you make any assumptions about what will happen to your trades. Policies will vary from one broker to another, and the rules will change periodically.
All options have a countdown timer attached to them. A put or call option will only last until its expiration date on the third Friday of its expiration month. That means that if your option expires in January of 2009 then the actual expiration date is 1/16/2009. Once expiration has passed the option no longer exists and is worthless. Therefore, most of your trades should be completed before the expiration date. This is usually not a problem if you buy an option with an adequate amount of lead time, which means that you need to consider whether a new trade has enough time to “work itself out” before you enter the position.
A long call gives the buyer the right to buy the stock before expiration for the strike price, and a put is the right to sell a stock for the strike price before expiration. “Exercising” an option is what happens when the call or put buyer actually uses that right to buy or sell the underlying stock. Most individual options traders never exercise their options. That is because the option can be sold on the open market before expiration without having to go to the trouble of exercising. However, if you decide that you do want to exercise your option you will need to call your broker and arrange the transaction directly with them.
If you still own your option and it is “in the money” on expiration Friday your broker will likely exercise your option automatically unless you give them specific instructions otherwise. That means that if you owned a single call option with a strike of $20, and the stock is worth $25 at expiration then you will find 100 shares of that stock in your account at a price of $20 on the following Monday. Be careful, because if you do not have enough cash to cover this purchase your broker may charge you a hefty fee.
This is an issue that option writers or sellers deal with. Writing, selling or shorting options means you are accepting the obligation to deliver on the option buyer’s rights. If you are short a put you may have to buy the stock at assignment if the put buyer decides to exercise her rights. Similarly, if you are short a call you may have to sell the stock for the strike price if the call buyer decides to exercise her option.