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Options Expiration & Assignment - Options Mechanics - Options Trading For Beginners - YouTube
Channel: Option Alpha
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Hey everyone.
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This is Kirk here again at OptionAlpha.com.
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In this video, we're going to go through the
entire options expiration and assignment process,
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and basically give you a rundown on everything
that you need to know.
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Now for new traders, expiration and assignment
can be a little scary and confusing, and I
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get that.
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But in today's video, we're going to break
it down in simple bite-sized chunks that give
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you a clear understanding of how it all works.
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And again, clear understanding equals confidence
in what you're going to be doing as you start
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getting deeper and deeper into options training.
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First, it's important that we remember that
options contracts have a finite expiration
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date and that they are derivatives of any
underlying stocks or ETFs or indexes.
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Therefore, they are regulated different than
an actual stock.
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So, I first want to introduce options expiration
and assignment by talking about the Options
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Clearing Corp., or OCC.
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Now this is the company, regulatory body,
whatever you want to call it.
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And that's jointly owned by all the exchanges
that trade options, and they issue all the
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options and control all the controls and effects
all exercises and assignments.
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And what's really important to understand
about the OCC is that they basically guarantee
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all trades by acting as a counter party to
any purchase or sale of options, thereby providing
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a liquid market to trade.
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Now, I'll get to a little graph here in a
second that kind of describes what OCC is.
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But again, it's their acting as a counter
party to guarantee all trades.
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They're not acting as the other person that
you're trading with.
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So, for example, if you're an option buyer,
you're not buying options directly from the
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OCC.
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They're not going to be the other party involved.
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You're still going to be buying options from
an option seller, but the OCC is going to
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kind of be the person in between there that
guarantees that if one party doesn't pay or
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can't provide payment that the other party
has made whole.
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So that you know that if you buy an option
or sell an option, and make money on that
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trade, that someone is going to be there to
pay those profits to you.
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So the OCC, like other clearing companies,
is the direct participant in every purchase
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and sale of an option contract.
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They act as kind of the "go between", they
kind of "barrier" between an option buyer
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and option seller.
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But again, they guarantee everything, that's
what's really important here.
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So, here's a quick little graphic we've gone
over before, but it's worth going over again.
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Again, if you are an option buyer, in this
case, then what you want to do is you would
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want to submit payment to the OCC.
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Okay, again, they are acting as not the middle
man but as the clearing part of it to guarantee
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the trade.
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They give that payment to the option writer,
or the option seller.
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The option writer then gives the OCC their
option contract, which then delivers the option
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contract to you.
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Now this all happens in a split second, right?
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And everything that we do in options trading
happens in a split second.
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But in the case of this video, what's important
to know is that there is an intermediary here
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that guarantees payment and liquidity.
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So there's an option writer and an option
buyer, or an option seller and an option buyer,
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doesn't matter, someone is going to be there
to guarantee that if this person decides if
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they can't pay ... Don't have enough money
in their account, whatever the case is, for
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some weird reason that they can't do it, OCC
will make you whole.
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And that's really the key part here.
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Now remember, options are expiration dates.
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We usually show these here at Option Alpha
with vertical lines on our chart.
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There's ways you can do that on a lot of different
broker platforms, I like to visually see it
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by showing these vertical green or vertical
red lines on my chart.
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But you can consider these kind of like the
make or break points.
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For right now, the time that we did this video,
we took this screenshot here of a stock and
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you can see this is where it's trading.
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And basically these are the different options'
expiration dates.
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So we could have the monthly dates, you could
have weekly dates.
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But basically this is the time frame you need
the stock to move before you could either
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make money or not.
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That's what's really important about option
expiration dates.
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Again, we've got a great little calendar and
resource guide here on Option Alpha that you
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can download.
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We usually have this current year plus a couple
current years out into the future if you've
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ever wanted to check that out.
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Again, it's completely free.
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The one that we use gives you all of the market
holidays as well so its very easy so for example
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January 1, that's New Year's, that's going
to be a market holiday, and then we've got
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March, if there's a market holiday there,
whatever the case is.
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And it also gives you the expiration dates
for the monthly contracts and the quarterly
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contracts.
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So in this case this is going to be the actual
expiration date for monthly contracts in January,
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again it's all the third Friday in the month
for the monthly contracts, that's the expiration
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date.
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The expiration date, or the day they actually
expire, and everything transfers over is actually
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that following Saturday, so that always happens
on the following Saturday.
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So again, really cool resource again 100%
free here at Option Alpha.
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So, a couple little quick tips before we get
into the exercise and assignment process for
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options.
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Again, expiration day for equity and index
options is the Saturday immediately following
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the third Friday of the expiration month (except
obviously when Friday's a holiday, in which
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case it was brought forward by one day to
Thursday).
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Okay, so again you can check our calendar
that we have, it's always there.
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But actual options expire on Saturday, the
last day they can trade is Friday.
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Most people consider Friday really the last
expiration day.
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So again, for American-style index option
contracts the last trading day is generally
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the third Friday, again unless it's a holiday
in which case it brings forward to Thursday.
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For European-style index option contracts,
and again we'll get into all this here later
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on in the video, but it's important to not
right off the bat, the last trading day will
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the business day, generally Thursday, preceding
the day in which exercise settlement value
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is calculated.
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An American-style options may be exercised
at any time prior to its expiration, and at
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anytime up to an including the third Friday
of expiration month.
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That's why third Friday is always considered
to be the last trading day.
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So you can see here, back on our calendar,
basically American-style options can be exercised,
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assigned anytime including that last Friday.
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So, last Friday of the expiration cycle is
usually the time where you want to get something
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done or make a change.
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A European-style index option may only be
exercised during a specific period of time,
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just prior to its expiration.
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Now this is generally the last Friday.
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Now we'll get into the differences between
European and American style options, but I
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wanted to introduce this real quick because
I think most people gloss over it, and I want
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to make sure we have clear understanding that
there are differences in American-style versus
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European-style.
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And it's not necessarily that those are American
options on the American market versus European
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options on the European market, it's a style
of contract, okay?
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So first, before we get into that, let's talk
through the actual options exercise process.
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Now this is really important because you have
to clearly, clearly understand what happens
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if you decide to exercise your option.
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Now there's tow different things we have to
talk about right?
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There's the options exercise, and then options
assignment.
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Exercising an option is when you are an option
buyer and you decide to exchange your option
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contract for the actual shares of underlying
stock.
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In this case, we'll use a call option in both
examples.
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Now option assignment, which we'll talk about
here next, that's when you are the option
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seller and the option buyer has decided to
exercise their contract and now you have to
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give up your shares of the actual underlying
option, okay?
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So that's what's really important here as
we go through.
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Now options exercise obviously starts with
a call option holder or call option buyer,
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or put option holder or put option buyer,
deciding to exercise their contract.
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So, whatever that happens, with American-style
options, which is 90% of the market, 95% of
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the market, that's going to happen at anytime
until expiration.
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So whenever that person decides "I want to
go ahead and exercise my option, they basically
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submit that request to their broker", okay?
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Now that can in the form a phone call, it
can come usually in the form of going into
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your online account, and choosing the option
to exercise the option versus to sell it back
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to the market, or whatever the case is.
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But, whatever they do, they submit that request
to their broker, so whoever your broker is,
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then receives that request.
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Immediately the broker sends a notice of exercise
to the OCC.
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So again, this is why I want to talk about
the OCC first in this video because now you
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can see where the OCC kind of comes into play
here a little bit more.
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Now the OCC receives that request immediately,
and they randomly select a member firm who
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is short an exercise call and assign them
the exercise.
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Now this is the key point, most people assume,
sometimes when they get into trading, that
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when you have a contract with somebody else
for the entry, meaning if I buy an option
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from you and you're the option seller, that
immediately we're tied together, and if you
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decide to do something that reflects upon
me and visa versa, that's not the case, we're
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jus parties involved for that initial contract.
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But what happens in the exercise an assignment
process is that it is randomly generated,
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meaning it's randomly assigned between brokers
and the actual call writer.
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So you don't know if you're going to get assigned
somebody's contract or not, it's all randomly
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done.
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So the first thing that happens again is that
that OCC randomly selects a member firm, so
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they can select your firm, or randomly select
a different firm.
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From there, the firm will select on a random
basis some of their clients that have those
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short options.
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So again, random firm, check, random assignment
of the call seller, okay?
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And at that point then the call seller will
then deliver the shares back through the process,
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okay?
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This is again the options exercise process,
this is if you're an option holder, an option
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buyer, and you decide to convert that option
contract into underlying shares whether long
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or short, all right?
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Now, let's go on the other side and talk about
the option assignment process.
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It's all the same stuff, but I just want to
talk about it a little bit different.
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Again, what happens now is that if you are
an option writer or an option seller, you
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will get assigned a contract.
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Now you don't know when this is going to happen,
because it's all random.
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If you do get assigned a contract, you'll
get notice from your broker that you've assigned.
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Once that happens, then you'll have to deliver
the contract to your broker, right?
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And that contract will then be converted into
the shares, and the shares will then be delivered
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to the OCC.
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So again, we kind of come full circle here,
and now the OCC receives the shares that came
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out of your account.
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Remember you got randomly assigned through
this process that we just talked about in
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exercise, and so now that you've been assigned,
you deliver the shares to your broker, the
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broker delivers them to the OCC.
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Immediately the OCC then delivers the shares
back to your broker, or the option buyer's
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broker, who then delivers the shares to the
option buyer, okay?
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So this entire process happens very quickly
and again the parties involved here include
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the OCC, which happens to be the intermediary,
they guarantee everything, they double check
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everything, and then your brokers act as that
direct links to the OCC and between you and
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the option buyer and option seller, okay?
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So again, hopefully that clears up the entire
process of exercise an assignment, and again
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we'll get through some more stuff here as
we get further into this training, all right?
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Now though options can be exercised or assigned
at any point, and we've talked about his before,
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it's important to remember that the vast,
vast majority of options are assigned the
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week of expiration- and really the last few
days.
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Now this is really a big one because even
though you can technically be assigned at
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any point.
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So, I can choose as an option buyer to assign
my contract to you as the option seller at
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any point, you have to really understand that
as an option buyer, if I sign early, I lose
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any time value or extrinsic value that that
contract has.
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And so, that means that generally most contracts
are assigned, or exercised, however you want
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to look at it.
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They are assigned or exercised the week of
expiration, because they are nearing their
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intrinsic value, they don't have this extra
component of volatility and time decay.
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Again, if I exercise early, I lose that as
an option buyer, and so that's why most option
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contracts are not exercised incredibly, incredibly
early.
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They're actually exercised later on in the
cycle, the vast majority of that coming the
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week of expiration and really, the last few
days, so Wednesday, Thursday, Friday.
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So what this means is that you shouldn't really
worry about expiration of an assignment as
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you're trading.
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I think when we went back recently and tracked
all of our trades for the last five years,
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and we've done thousands of trades over the
last five years, we were assigned on contracts,
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I think just over 1%, like 1.2% of the time,
we were assigned contracts.
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So, it is very rare to happen.
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And again, you got to deal with stuff the
week of expiration, you can't run yourself
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all the way to the end until the limit, and
hold a contract that's in the money the few
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days of expiration.
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You do have to manage that risk obviously,
and we teach you how to do that here at Option
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Alpha.
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But, as far as numbers go, we've only been
assigned about 1.2% of the time over the last
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five years.
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So that gives you a little bit of confidence
to know that most of this assignment exercise
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process doesn't happen all too often.
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It can definitely happen, and if you trade
long enough it will.
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But it's not something that you need to freak
out about and hyperventilate about.
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All right, so let's continue to go through
here, we've got a couple more things that
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we need to cover.
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First, we need to cover the difference between
physical and cash settlement.
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Now physical settlement are option contracts
whereby settlement requires the actual physical
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delivery of the underlying security.
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Most of the options you will find in the marketplace
are physically settled options, like stock
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options, since the underlying stock is transferred
and delivered.
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Now this is what we've generally talked about
all through Track 1, most of the trading that
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we do at Option Alpha is in regard to physical
settlement, where if you are assigned or if
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you exercise, you want to get or receive the
underlying shares of whatever you're trading.
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So for example here, we have Google stock.
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If you're trading Google options, you'd want
to get or receive Google shares, okay?
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Now there is a difference because there are
also cash settled options.
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And these are options/contracts whereby settlement
is done via the payment of cash at exercise
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at expiration.
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This is typically the settlement that is preferred
when delivering an underlying security that
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is inconvenient, costly, or simply impossible
to give.
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And you want to think here of the SPX and
VIX options.
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Most index options are cash settled, and the
reason that they're cash settled is that you
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can't go out and buy an index, you can't go
out and buy SPX, it's just a benchmark index.
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So, although there is options on SPX, when
actual assignment or expiration comes, you
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actually get just the cash value of your options
of your contracts at expiration.
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So, you either make money or you didn't, there's
no actually delivery of the SPX index, because
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it's nonexistent, it's impossible to deliver
the index, okay?
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Now most of the stuff that we do here at Option
Alpha, like I said, is physical settlement,
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this does include ETFs, because you can buy
ETFs, those are physical securities.
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But, a lot of things out there are cash settled
as well, and it's mostly some of the index:
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SPX, RUT, VIX, NDX, etc.
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Now again, we talked about this before, but
it's worth mentioning here again towards the
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end again, is that there are two different
types of options, and it's really important
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that we distinguish between these.
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The first is American options.
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You can American-style options any time before
expiration.
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So for example if you own a call option and
there are fifteen days before expiration,
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you can choose to exercise that option and
buy stock at the strike price.
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Now this is different than European options.
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European options are only exercised at expiration.
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And so most of the index and forex options
(again like RUT, SPX, NDX, etc. that we talked
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about) are typically European-style, and the
reason they are is because those are usually
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cash settled indexes as well because you're
not going to do an early exercise of SPX and
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buy SPX, it's impossible to get delivery of
an index.
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So that's why most of those are European-style.
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Again, they're less common, just like cash
settlement is less common.
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Most of the options that are out there are
American-style, which means they can be exercised
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anytime before expiration.
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What's really, really important to remember
here about American-style options, since this
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is most of what we do here, is that this is
only dealing exercise and assignment.
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It has nothing to do either European or American-style
with the ability to buy or sell contracts.
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So, if you have an American-style option or
European-style option, you can still buy and
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sell those contracts all the time, back and
forth, as many times as you want, up until
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expiration.
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You can buy a call, sell it back, buy a call,
sell it back, buy a put, sell it back, buy
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a put, sell it back, you can do this all the
time.
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It's only when it comes to the actual exercise
of that option where you want to convert a
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contract into underlying shares, that's where
the difference comes in here between American
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and European styles.
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So, hopefully that makes sense.
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Again, most of what we do here at Option Alpha
is physical settlement and American-style
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options, and again, that's the most widely
used type of contracts out there.
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So, hopefully this has been a really good
video tutorial on the entire options expiration,
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assignment exercise process.
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Again, I appreciate you taking the time to
watch it.
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If you have any comments or feedback, please
leave them in the comment section below.
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If you love this video, please help us out
by sharing it online, it's one of the ways
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we spread the word here at Option Alpha.
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And until next time, happy trading.
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