Exercise & Assignment

Exercise Procedures and Mechanics

Exercise is the process by which an option holder elects to invoke the rights of the options contract. For call options, exercise means buying the underlying security at the strike price; for put options, exercise means selling the underlying security at the strike price. The Registered Options Principal must understand and supervise the exercise process to ensure customer instructions are executed properly and that the firm's obligations are fulfilled.

Under the OCC Rules, standardized options can be exercised on any business day during the option's life for American-style options. European-style options can only be exercised at expiration. Most equity options are American-style, while many index options are European-style. The ROP must ensure that registered representatives understand this distinction and communicate it correctly to customers.

Customer Exercise Instructions

When a customer wishes to exercise an option, they must provide explicit instructions to their broker-dealer. The firm's procedures for accepting exercise instructions typically include:

• Exercise Notice Deadline: Customers must provide exercise instructions by the firm's internal deadline, which is typically earlier than the OCC's deadline. Many firms require exercise instructions by 5:30 PM ET on the last trading day before expiration.
• Proper Account Verification: The firm must verify that the customer holds the long option position and that the position is eligible for exercise.
• Financial Verification: For call exercises, the firm must verify that the customer has adequate funds to purchase the underlying shares (or adequate margin if in a margin account). For put exercises, the firm must verify that the customer owns the underlying shares to be delivered.
• Written Documentation: Exercise instructions should be documented in writing or through a recorded telephone line. The ROP must ensure documentation requirements are met.

Firm-to-OCC Submission

Once the broker-dealer receives a valid exercise instruction from a customer, the firm submits an exercise notice to the Options Clearing Corporation through its clearing member. The OCC has established specific deadlines for receiving exercise notices:

• Standard Exercise Cutoff: 5:30 PM ET on the business day prior to expiration for expiring options
• Contrary Exercise Instructions: Used when a customer wants to prevent automatic exercise (discussed below) or exercise an option that would not be automatically exercised. These must typically be submitted by 5:30 PM ET.
• Extended Hours: Some options on certain securities may have exercise rights during extended trading hours, with corresponding extended exercise notice deadlines.

The OCC's Role in Exercise and Assignment

The Options Clearing Corporation serves as the central clearinghouse for all standardized options traded on U.S. exchanges. The OCC is the issuer and guarantor of every listed option, standing between buyers and sellers. When a holder exercises an option, the OCC facilitates the process and assigns the obligation to a short position holder.

OCC as Issuer and Guarantor

When an options transaction occurs, the OCC effectively becomes the buyer to every seller and the seller to every buyer. This central counterparty role means that:

• Long position holders look to the OCC for performance when they exercise
• Short position holders face assignment obligations from the OCC, not from a specific counterparty
• The OCC guarantees completion of all valid exercises and assignments
• The OCC maintains a substantial clearing fund and has loss mutualization agreements to ensure it can meet its obligations

The ROP must understand that the OCC's guarantee is a cornerstone of the U.S. options market's integrity. This guarantee eliminates counterparty risk from the options market, meaning option holders need not worry about whether the other party can fulfill the contract's obligations.

Position Reconciliation

The OCC maintains comprehensive records of all open options positions through reports submitted by its clearing members. Each business day, clearing members reconcile their positions with the OCC. The ROP must ensure that the firm's internal position records match the OCC's records, as discrepancies can lead to processing errors during exercise and assignment.

Automatic Exercise Thresholds

One of the most important OCC procedures that the ROP must understand is automatic exercise, also called "exercise by exception." This procedure was implemented to protect customers who hold in-the-money options at expiration but fail to provide exercise instructions.

Current Automatic Exercise Thresholds (2026)

Under OCC rules, the automatic exercise thresholds are:

• Equity Options: Automatically exercised if $0.01 or more in-the-money at expiration
• Broad-Based Index Options (e.g., SPX): Automatically exercised if $0.01 or more in-the-money at expiration
• Narrow-Based Index Options: Automatically exercised if $0.01 or more in-the-money at expiration
• ETF Options: Automatically exercised if $0.01 or more in-the-money at expiration

The $0.01 threshold applies universally across all standard equity and equity-index options. This replaced the previous higher thresholds and was implemented to better protect retail customers from inadvertently allowing valuable options to expire worthless.

Exercise by Exception Procedures

The exercise by exception process works as follows:

1. Position Identification: On expiration Friday, the OCC identifies all options positions that meet the automatic exercise threshold.
2. Automatic Processing: Unless the clearing member submits a contrary instruction (Do Not Exercise notice), the OCC automatically exercises these positions.
3. Assignment Processing: The OCC then assigns the obligations resulting from these exercises (and any voluntary exercises) to short position holders.
4. Settlement: Stock delivery and payment settle through the normal settlement cycle (T+1 for equity options).

Do Not Exercise (DNE) Instructions

There are situations where a customer may not want an in-the-money option to be exercised, even though it would be automatically exercised under OCC rules. Common scenarios include:

• The customer lacks sufficient funds or margin to take delivery of the underlying shares (call exercise)
• The customer does not own the underlying shares to deliver (put exercise)
• Transaction costs of exercising and immediately closing the stock position would exceed the intrinsic value
• The customer wants to close the position in the options market rather than converting to stock

The ROP must ensure that the firm has procedures for accepting and submitting Do Not Exercise instructions to the OCC by the deadline (typically 5:30 PM ET on expiration day).

Assignment Process and Random Allocation

Assignment is the other side of the exercise process. When option holders exercise their rights, the OCC assigns the corresponding obligations to option writers (short positions). Understanding the assignment process is essential for the ROP, as assignment can create unexpected positions and obligations for customers with short options.

OCC Random Allocation Method

When the OCC receives exercise notices for a particular option series, it must determine which specific short positions will be assigned. The OCC uses a random allocation system:

1. Exercise Aggregation: The OCC aggregates all exercise notices received for each option series.
2. Random Selection: The OCC uses a random number generator to select clearing members in proportion to their short positions. If 1,000 contracts are exercised and a clearing member holds 10% of the short open interest, that clearing member would expect to receive approximately 100 assignment notices (though the random process means the actual number may vary slightly).
3. Member-Level Allocation: Each clearing member receives assignment notices from the OCC. The clearing member must then allocate these assignments among its customer and proprietary accounts.
4. Firm Allocation Methods: Broker-dealers typically use one of three methods for allocating assignments: random, first-in-first-out (FIFO), or pro-rata. FINRA and exchange rules permit any reasonable allocation method, but the firm must apply its chosen method consistently and disclose it to customers.

Assignment Notification

Assignment notifications flow from the OCC to clearing members, and then from clearing members to broker-dealers and their customers. The timeline is:

• Exercise Day (T): Exercises are submitted to the OCC by 5:30 PM ET
• Assignment Day (T): The OCC processes exercises and allocates assignments overnight. By early morning of T+1, clearing members receive assignment notices.
• Notification Day (T+1): Broker-dealers notify customers of assignments. Many firms provide notification electronically through the customer's online account interface. Settlement processing begins.
• Settlement Day (T+1): Stock and cash settle. For equity options, the standard settlement cycle is T+1 (next business day).

The ROP must ensure that the firm has effective procedures for promptly notifying customers of assignments, as customers may need to take action quickly to manage the resulting stock position or meet margin calls.

Firm Allocation Methods

Settlement Obligations and Timelines

Exercise and assignment create settlement obligations that must be fulfilled according to specific timelines. The ROP must ensure that customers understand and can meet these obligations, and that the firm's operations and margin departments are prepared to handle settlement.

Settlement Cycle for Equity Options

When an equity option is exercised:

• Call Exercise Settlement (T+1): The call holder (exerciser) must pay the total purchase price (strike price × number of shares) and receives the shares. The call writer (assignee) must deliver the shares and receives the payment. Settlement occurs T+1 (next business day).
• Put Exercise Settlement (T+1): The put holder (exerciser) must deliver the shares and receives the total sale proceeds (strike price × number of shares). The put writer (assignee) must pay for the shares and receives the shares. Settlement occurs T+1.

Settlement Timeline Comparison

Margin and Financial Requirements

Exercise and assignment can create significant financial obligations. The ROP must ensure the firm monitors accounts for adequate margin and equity to meet settlement obligations:

• Call Exercise (Long): Requires payment of the full strike price. In a cash account, funds must be available. In a margin account, Regulation T margin applies (currently 50% initial margin on the resulting long stock position).
• Call Assignment (Short): If the customer owns the stock (covered call), shares are simply delivered. If the customer doesn't own the stock (uncovered/naked call), this creates a short stock position requiring substantial margin (typically 30% of stock value plus the out-of-the-money amount, if any).
• Put Exercise (Long): If the customer owns the stock, shares are delivered. If the customer doesn't own the stock, this creates a short stock position requiring margin.
• Put Assignment (Short): Requires payment of the full strike price. If adequate funds are not available, this may trigger a margin call.

Expiration Processing and ROP Responsibilities

Expiration Friday (the third Friday of the expiration month for monthly options) is one of the most critical days for options supervision. The ROP must ensure that comprehensive procedures are in place to manage the exercise, assignment, and expiration process efficiently and in customers' best interests.

Pre-Expiration Customer Communication

Best practices for ROPs include implementing procedures for proactive customer communication before expiration:

• At-Risk Position Identification: By the Wednesday or Thursday before expiration, identify all customers holding expiring options positions, particularly those that are in-the-money.
• Customer Outreach: Contact customers with material expiring positions to discuss their intentions. Confirm whether they want to exercise, close the position, or let it expire.
• Margin Adequacy Review: For customers whose options are in-the-money and likely to be automatically exercised, verify that they have adequate margin or cash to take delivery of the underlying position.
• Documentation: Document all customer conversations and instructions regarding expiring positions.

Expiration Day Procedures

On expiration Friday, the ROP should ensure the following procedures are executed:

1. Trading Deadline Monitoring: Options cease trading at 4:00 PM ET on expiration day. Monitor to ensure no late orders are accepted after the cutoff.
2. Exercise Instruction Deadline: Enforce the firm's internal exercise instruction deadline (typically 5:30 PM ET for most firms). Late instructions may not be processable.
3. Automatic Exercise Review: Review all positions subject to automatic exercise. Submit Do Not Exercise instructions where appropriate (e.g., accounts lacking margin for the resulting position).
4. OCC Submission: Ensure all exercise and Do Not Exercise instructions are submitted to the OCC by the deadline.
5. Settlement Preparation: Prepare for next-day settlement of exercises and assignments. Ensure clearing operations are staffed adequately.

Post-Expiration Processing

The business day following expiration (settlement day):

• Assignment Notification: Review assignment notices from the OCC. Allocate assignments to customer accounts according to the firm's allocation method.
• Customer Notification: Notify customers of assignments promptly. Many customers will need to take immediate action to close out the resulting stock position or meet margin calls.
• Margin Call Issuance: Issue margin calls for accounts that are undermargined due to exercise or assignment.
• Settlement Monitoring: Monitor settlement of all exercise and assignment obligations. Ensure stock and cash are delivered as required.
• Exception Handling: Address any settlement failures, processing errors, or customer disputes.

Common Expiration Issues and Solutions