Index Options - Part Four

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...Continued from Part Three.

Exercise & Assignment Ctd.
Upon receipt of an exercise notice, OCC will assign it to one or more Clearing Members with short positions in the same series in accordance with its established procedures. The Clearing Member will, in turn, assign one or more of its customers, either randomly or on a first-in first-out basis, who hold short positions in that series.

Upon assignment of the exercise notice, the writer of the index option has the obligation to pay this amount of cash. Settlement and the resulting transfer of cash generally occur on the next business day after exercise.

Note: Most firms require their customers to notify the firm of the customer's intention to exercise at expiration, even if an option is in-the-money. You should ask your firm to thoroughly explain its exercise procedures, including any deadline your firm may have for exercise instructions on the last trading day before expiration.

AM & PM Settlement
The exercise settlement values of equity index options are determined by their reporting authorities in a variety of ways. The two most common are:

PM settlement - Exercise settlement values are based on the reported level of the index calculated with the last reported prices of the index's component stocks at the close of market hours on the day of exercise.

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AM settlement - Exercise settlement values are based on the reported level of the index calculated with the opening prices of the index's component stocks on the day of exercise.

If a particular component security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used.

Investors should be aware that the exercise settlement value of an index option that is derived from the opening prices of the component securities may not be reported for several hours following the opening of trading in those securities. A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported. There could be a substantial divergence between those reported index levels and the reported exercise settlement value.

American vs. European Exercise
Although equity option contracts generally have only American-style expirations, index options can have either American- or European-style.

In the case of an American-style option, the holder of the option has the right to exercise it on or at any time before its expiration date. Otherwise, the option will expire worthless and cease to exist as a financial instrument. It follows that the writer of an American-style option can be assigned at any time, either when or before the option expires, although early assignment is not always predictable.

A European-style option is one that can only be exercised during a specified period of time prior to its expiration. This period may vary with different classes of index options. Likewise, the writer of a European-style option can be assigned only during this exercise period.

Exercise Settlement
The amount of cash received upon exercise of an index option or when it expires depends on the closing value of the underlying index in comparison to the strike price of the index option. The amount of cash changing hands is called the exercise settlement amount.

This amount is calculated as the difference between the strike price of the option and the level of the underlying index reported as its exercise settlement value, in other words, the option's intrinsic value, and is generally multiplied by $100. This calculation applies whether the option is exercised before or at its expiration.

In the case of a call, if the underlying index value is above the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 79.55, the holder of a long call contract with a 78 strike price would exercise and receive $155 [(79.55 - 78) x $100 = $155]. The writer of the option would pay the holder this cash amount.

In the case of a put, if the underlying index value is below the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as 74.88 the holder of a long put contract with a 78 strike price would exercise and receive $312 [(78 - 74.88) x $100 = $312]. The writer of the option would pay the holder this cash amount.

Closing Transactions
As with equity options, an index option writer wishing to close out his position buys a contract with the same terms in the marketplace. In order to avoid assignment and its inherent obligations, the option writer must buy this contract before the close of the market on any given day to avoid notification of assignment on the next business day.

To close out a long position, the purchaser of an index option can either sell the contract in the marketplace or exercise it if profitable to do so.

To Be Continued in Part 5
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