Option Basics: Why Should I Care If There's An Early Exercise of OEX Options? (6:2)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 6, No. 2 on January 22, 1997.

During expiration week, we often talk about the importance of monitoring option activity in OEX because it can have an influence on the overall market. This is especially important for stock traders and stock index futures traders. Whether you're short-term oriented or merely wanting to know what's going on, you should understand the ramifications of an early exercise of OEX options.

First, let's point out two things that distinguish OEX options from many other options that are trading. First, they are American style, which means that they can be exercised at any time during their life. This is as opposed to European style options, which can only be exercised upon expiration. Most index and sector options are of the European type and therefore, by definition, they cannot be the subject of "early exercise", but OEX can because they are American style.

The second distinguishing feature of OEX options is that they are cash-settled, which means that — upon exercise or assignment — your account is credited (exercise) or debited (assignment) with the difference between OEX's closing value and the strike price of the option. No shares of stock actually change hands, even though the OEX Index itself is composed of varying amounts of 100 different stocks. This distinction becomes extremely important in hedged situations. If an arbitrageur is long an IBM in-the-money call and short 100 shares of IBM, he completely closes out his position by exercising the call because he receives 100 physical shares of IBM when he exercises that call. However, that is not the case with OEX where there is plenty of effect when even a hedged position is removed, for the stocks themselves must be traded in the open market. This is what happens at the end of each expiration Friday when OEX options expire.

Our purpose in this article, though, is to investigate what effect an early exercise and its concomitant assignment has. It is best demonstrated from the viewpoint of the trader receiving the assignment. If you are short an IBM call, your market position is not changed if you receive an assignment. For example, if you are long stock and short a deeply in-the-money call, you basically have no market exposure. If the call is assigned, your position is eliminated and you still have no market exposure.

However, when a cash-settled option is assigned, your market exposure can be radically changed. Suppose that a trader has the following position, with OEX at 750, as January expiration approaches:

Both options have deltas nearly equal to 1.0 (the maximum) and there is no market exposure. The long calls are equally counterbalanced by the movement in the short calls, as the market fluctuates up and down.

But if an assignment is received, he will have acquired a huge exposure. Suppose that OEX closed at 750 one evening, and he arrives at work the next morning to find that all of his Jan 730 calls have been assigned. His account will be debited $20,000 since the 10 short calls are twenty points in-the-money (750 – 730), and the short calls will be removed from the account. He is therefore left only with a position of long ten Jan 730 calls.

Consequently, he has a heavy downside market exposure as the market opens. Now, most traders absolutely abhor such an instantaneous change in their market exposure — especially if it is created by an outside force, such as a call assignment. Therefore, the trader goes into the open market and attempts to hedge his position — he may sell stocks or sell futures, but he will sell something to reduce his market exposure. If enough calls were exercised, and therefore enough traders need to hedge themselves, that OEX call exercise will translate into a downside market opening the next day as traders sell stock and futures, just as the trader in the above example did.

Without going into as much detail, a large early OEX put assignment will cause hedged traders to be extremely delta short, and they will have to buy something — stocks or futures — to re-establish their hedges, and the market will rise on the opening as a result.

A corollary to all of this is that the effect of traders reestablishing their hedges is normally short-lived, so the market will often quickly retrace the distance it moved because of the early exercise. That is, if the market gaps lower because of an OEX call exercise, it may go down for a half hour or so, but often rises and quickly closes that gap after traders have re-established their hedges.

It behooves one to pay attention to how much exercise activity is going on during expiration week. If you are a short-term trader, you might want to buy the market when it gaps lower after a call exercise (for a quick trade). If you are stock investor, you might place bids for stocks that you like that are part of the OEX, figuring that they may be artificially sold down on the opening. You would take opposite actions if there had been a put exercise. The easiest way to check exercise activity is to call 312-786-7955, ext. 5, each morning before the market opens.

This article was originally published in The Option Strategist Newsletter Volume 6, No. 2 on January 22, 1997.